What Is a Dual Currency Swap?

A dual currency swap is a type of derivative transaction that allows investors to hedge the currency risks associated with dual currency bonds. They involve agreeing ahead of time to exchange either the principal or the interest payments from the dual currency bonds in a particular currency at predetermined exchange rates.

Dual currency swaps can help companies issue dual currency bonds by making them less exposed to the risks associated with being paid in foreign currencies. Similarly, from the bond investor's perspective, dual currency swaps can reduce the risk of purchasing bonds denominated in foreign currencies.

Key Takeaways

  • A dual currency swap is a derivative transaction that allows the parties involved to reduce their exposure to foreign exchange risk.
  • It is commonly used as a complement to dual currency bond transactions.
  • Dual currency swaps involve exchanging the principal and interest repayment obligations associated with a dual currency bond. The timing and terms of the dual currency swap would be structured to offset, or hedge, the bond's currency risk.

Understanding Dual Currency Swaps

The purpose of a dual currency swap is to make it easier to buy and sell bonds denominated in different currencies. For instance, a company might benefit from making its bonds available to foreign investors, in order to access a larger pool of capital or to enjoy better terms. On the other hand, investors might find the bonds of a foreign company more attractive than those available in their home country. To accommodate this market demand, companies and investors can use dual currency bonds, which are a type of bond in which the interest and principal payments are made in two different currencies.

Although dual currency bonds can make it easier for companies and investors to buy and sell bonds internationally, they do introduce their own unique risks. Not only do these investors need to concern themselves with the usual risks of bond investment, such as the credit worthiness of the issuer, but they must also transact in a foreign currency whose value might fluctuate to their detriment during the term of the bond.

Dual currency swaps are a type of derivative product in which the buyer and seller of a dual currency bond agree ahead of time to pay the principal and interest components of the bond in a particular currency, and at predetermined exchange rates. This flexibility comes at a cost, which is the price, or premium, of the swap agreement.

Real World Example of a Dual Currency Swap

Eurocorp is a European company wishing to borrow $50 million USD in order to construct a factory in the United States. Meanwhile, Americorp, an American company, wishes to borrow $50 million USD worth of euros in order to build a factory in Europe.

Both of these companies issue bonds in order to raise the capital they need. They then arrange a dual currency swap between one-another, in order to reduce their respective currency risks. Under the terms of the dual currency swap, Eurocorp and Americorp swap the principal and interest rate repayment obligations associated with their bond issuances. Moreover, they agree ahead of time to use particular exchange rates, so that they are less exposed to potential adverse movements in the foreign exchange market. Importantly, the swap agreement is structured so that its maturity date aligns with the maturity date of both companies' bonds.

Under the terms of their swap agreement, Eurocorp delivers $50 million USD to Americorp and receives an equivalent amount of euros in return. Eurocorp then pays interest denominated in euros to Americorp, and receives an equivalent amount of interest denominated in USD.

Because of this transaction, Eurocorp is able to service the interest payments on their initial bond issuance using the USD interest payments that they receive from their swap agreement with Americorp. Likewise, Americorp can service its bond interest payments using the euros received from its swap agreement with Eurocorp.

Once the maturity date for the companies' bonds comes due, they reverse the exchange of principal that occurred at the beginning of their swap agreement and return that principal to their bond investors. In the end, both companies benefited from the swap agreement because it enabled them to reduce their exposure to currency risks.