Currency swap

A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage.^[1] A currency swap should be distinguished from a central bank liquidity swap.

Structure

Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.^[1]

There are three different ways in which currency swaps can exchange loans:

1. The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.^[2]
2. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.^[2]
3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross-currency swap.^[3]

Uses

Currency swaps have two main uses:

• To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).^[2]
• To hedge against (reduce exposure to) exchange rate fluctuations.^[2]

Hedging example

For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following:

• If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency.
• Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.

Abuses

In May 2011, Charles Munger of Berkshire Hathaway Inc. accused international investment banks of facilitating market abuse by national governments. For example, "Goldman Sachs helped Greece raise $1 billion of off- balance-sheet funding in 2002 through a currency swap, allowing the government to hide debt."^[4] Greece had previously succeeded in getting clearance to join the euro on 1 January 2001, in time for the physical launch in 2002, by faking its deficit figures.^[5]

History

Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling.^[6] While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage.

Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years.^[7]

During the global financial crisis of 2008, the currency swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central bank of a developed^[8] or stable emerging^[9] economy agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S. dollars to overseas markets."^[10] While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term.^[11]

The People's Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, South Korea and Uzbekistan that perform a similar function to central bank liquidity swaps.^{[12] [13][14]}

Currency Swap Example

Company A is doing business in USA, and it has issued a $20 million dollar-denominated bond to investors in the US. Company B is doing business in Europe, and It has issued a bond of $ 15 Million Euros. The two companies can enter into an agreement to exchange the principal and interest of the bonds. The $15 million Euro-denominated bond will be the obligation of company A, and company B will be obligated to the $20 million bond. ^[15]

References

1. ^ ^{a b} http://www.finpipe.com/currswaps.htm
2. ^ ^{a b c d} Financial Management Study Manual - ICAEW (second ed.). Institute of Chartered Accountants in England & Wales (Milton Keynes). 2008 [2007]. pp. 462–3. ISBN 978-1-84152-569-3. 
3. ^ http://www.isda.org/educat/faqs.html#22
4. ^ Wall Street Bankers Share Blame for Europe Crisis, Berkshire’s Munger Says – Bloomberg, 2 May 2011
5. ^ Greece admits fudging euro entry, BBC
6. ^ http://books.google.co.uk/books?id=YDiHUIQk3C4C&pg=PA24
7. ^ http://faculty.london.edu/ruppal/zenSlides/zCH10%20Swaps.slide.doc
8. ^ http://www.federalreserve.gov/newsevents/press/monetary/20081029b.htm
9. ^ Chan, Fiona (2008-10-31). "Fed swap line for S'pore". The Straits Times. http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_296838.html. Retrieved 2008-10-31. 
10. ^ http://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm
11. ^ http://www.moslereconomics.com/2009/04/13/fed-foreign-currency-swap-lines/
12. ^ http://www.chinadaily.com.cn/china/2009-03/31/content_7635007.htm
13. ^ "China signs 700 mln yuan currency swap deal with Uzbekistan". Reuters. 2011-04-19. http://www.reuters.com/article/2011/04/19/china-uzbekistan-swap-idUSB9E7EN02P20110419. 
14. ^ http://uzpedia.blogspot.com/2011/04/uzbekistan-signs-currency-swap-deal.html
15. ^ http://www.svtuition.org/2011/07/currency-swap-examples.html