What Are Interest Rate and Currency Swaps?
Currency and interest rate swaps allow companies to navigate the global markets more efficiently. Currency and interest rate swaps bring together two parties that have an advantage in different markets. In general, both interest rate and currency swaps have the same benefits for a company.
- Interest rate and currency swaps differ in terms of the interest paid on the principal amount and the currency used for payment.
- An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount.
- A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency.
- A currency swap is considered a foreign exchange transaction and, thus, an "off-balance-sheet" transaction.
Understanding Interest Rate and Currency Swaps
Interest rate and currency swaps differ in terms of the interest paid on the principal amount and the currency used for payment.
Interest Rate Swaps
An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount. For an interest rate swap, the principal amount is not actually exchanged. Instead, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate, which is usually LIBOR. LIBOR is a benchmark rate that represents the interest rate at which banks lend funds to each other on the international interbank market for short-term loans.
A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract.
In the case of companies, these derivatives or securities help limit or manage exposure to fluctuations in interest rates or acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are often used because a domestic firm can usually receive better rates than a foreign firm.
A currency swap is considered a foreign exchange transaction and, as such, they are not legally required to be shown on a company's balance sheet. This means that they are "off-balance-sheet" transactions, and a company might have debt from swaps that are not disclosed in their financial statements.
Leveraging Global Markets Through Currency and Interest Rate Swaps
Suppose company A is located in the United States and company B is located in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a swap to take advantage of the fact that each company has better rates in its respective country. These two companies could receive interest rate savings by combining the privileged access they have in their own markets.
Swaps also help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Swapping allows companies to revise their debt conditions to take advantage of current or expected future market conditions. Currency and interest rate swaps are used as financial tools to lower the amount needed to service a debt as a result of these advantages.
The benefits that a company receives from participating in a swap far outweigh the costs, although there is some risk associated with the possibility that the other party will fail to meet its obligations.