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a loan and the interest in one currency for the principal and interest in another currency.
At the inception of the swap, the equivalent principal amounts are exchanged at the
spot rate.
During the length of the swap each party pays the interest on the swapped principal
loan amount.
At the end of the swap the principal amounts are swapped back at either the prevailing
spot rate, or at a pre-agreed rate such as the rate of the original exchange of principals.
Using the original rate would remove transaction risk on the swap.
Currency swaps are used to obtain foreign currency loans at a better interest rate than a
company could obtain by borrowing directly in a foreign market or as a method of
hedging transaction risk on foreign currency loans which it has already taken out.
We will consider how a fixed for fixed currency swap works by looking at an example.
An American company may be able to borrow in the United States at a rate of 6%, but
requires a loan in rand for an investment in South Africa, where the relevant borrowing
rate is 9%. At the same time, a South African company wishes to finance a project in
the United States, where its direct borrowing rate is 11%, compared to a borrowing rate
of 8% in South Africa.
Each party can benefit from the other's interest rate through a fixed-for-fixed currency
swap. In this case, the American company can borrow U.S. dollars for 6%, and then it
can lend the funds to the South African company at 6%. The South African company
can borrow South African rand at 8%, then lend the funds to the U.S. company for the
same amount.
Currency swaps can also involve exchanging two variable rate loans, or fixed rate
borrowing for variable rate borrowing. Let’s consider a case where a company
exchanges fixed rate borrowing for variable rate borrowing.
Barrow Co, a company based in the USA, wants to borrow €500m over five years to
finance an investment in the Eurozone.
Today’s spot exchange rate between the Euro and US $ is €1·1200 = $1.
Barrow Co’s bank can arrange a currency swap with Greening Co. The swap would be
for the principal amount of €500m, with a swap of principal immediately and in five
years’ time, with both these exchanges being at today’s spot rate.
Barrow Co’s bank would charge an annual fee of 0.4% in € for arranging the swap.
The benefit of the swap will be split equally between the two parties.
Barrow Co Greening Co
We will see what the gain on the swap for each party will be.
Using this gain to work out the overall result for each company, we can provide an
illustration of how the swap could work as follows:
Barrow Co Greening Co
Swap
The overall result show each party paying 0.6% less than they would have paid in they
had borrowed directly in the foreign markets.
Barrow Co’s original principal amount of €500m would be exchanged at the inception of
the swap for $446,428,517. The principal would be swapped back five years later, at the
end of the agreement, at the original spot rate.