DEFINITION of Dual Currency Swap
A dual currency swap is a derivatives contract established between two counterparties used to hedge the risk associated with the issuance of a dual currency bond. A dual currency swap allows the bond issuer to repay the principal and coupon in either the base currency or another currency. Exchange rates are preset in dual currency swaps at the time that they are initiated.
BREAKING DOWN Dual Currency Swap
A dual currency swap is essentially a mirror of a dual currency bond. In a dual currency swap, the issuer exchanges a floating rate for a fixed one. The bond issuer is willing to take on the currency risk in order to lower borrowing costs by making payments in a currency other than the base currency.
A dual currency bond is a synthetic security where the notional (nominal) value is established using one currency while interest payments made over the life of the bond are made in another currency. For instance, a bond issued in Canadian dollars, but which pays interest in Swiss Francs would be considered a dual currency bond. With some dual currency bonds, the interest must be paid in the buyer's home currency while the principal is redeemed in the issuer’s (seller's) domestic currency. Still other dual currency bonds operate in reverse. The coupon interest on a dual currency bond is usually set at a higher rate than comparable straight fixed-rate bonds and is typically paid in the currency that is deemed to be weaker.
A dual currency swap allows for flexibility in the repayment of either the principal and/or the interest payments using either currency. This flexibility comes with a cost, which is generally the price of the swap agreement.
Example of a Dual Currency Swap
For example, suppose that a European company borrows $50 million from an American bank to establish their first manufacturing facility in the United States. Because the company is located in Europe but will be building in the U.S., they decide it is best to use a dual currency bond where the principal is established in U.S. dollar, but the interest will be paid in euros. In order to reduce the risks associated with this sort of borrowing , the company enters into a dual currency swap involving euros and dollars. The company pays the swap counterparty the $50 million for the equivalent amount of euros, and receives interest payments in dollars at a fixed rate (which allow the company to service the bond). Upon the bond's maturity, the company receives the $50 million, and pays the counterparty the equivalent value in euros.