Introduction Currency Swaps

Introduction Currency Swaps

Swaps involve exchange of a series of payments between two parties. Normally, this exchange is effected through an inter­mediary financial institution. Though swaps are not financing instruments in themselves, yet they enable obtainment of desired form of financing in terms of currency and interest rate. Swaps are over-the-counter instruments.

The market of currency swaps has been developing at a rapid pace for the last fifteen years. As a result, this is now the second most important market after the spot currency mar­ket. In fact, currency swaps have succeeded parallel loans, which had developed in countries where exchange control was in operation. In parallel loans, two parties situated in two dif­ferent countries agreed to give each other loans of equal value and same maturity, each denominated in the currency of the lender. While initial loan was given at spot rate, reimburse­ment of principal as well as interest took into account forward rate.

However, these parallel loans presented a number of difficul­ties. For instance, default of payment by one party did not free the other party of its obligations of payment. In contrast, in a swap deal, if one party defaults, the counterparty is automatically relived of its obligation.

Currency swaps can be divided into three categories: -­

(a)    fixed-to-fixed currency swap,

(b) floating-to-floating currency swap, 

(c) fixed-to-floating currency swap.

A fixed-to-fixed currency swap is an agreement between two par­ties who exchange future financial flows denominated in two different currencies. A currency swap can be understood as a combination of simultaneous spot sale of a currency and a for­ward purchase of the same amounts of currency. This double operation does not involve currency risk. In the beginning of exchange contract, counterparties exchange specific amount of two currencies. Subsequently, they settle interest according to an agreed arrangement. During the life of swap contract, each party pays the other the interest streams and finally they reim­burse each other the principal of the swap.

 A simple currency swap enables the substitution of one debt denominated in one currency at a fixed rate to a debt denominated in another cur­rency also at a fixed rate. It enables both parties to draw ben­efit from the differences of interest rates existing on segmented markets. A similar operation is done with regard to floating-to- floating rate swap.

A fixed-to-floating currency coupon swap is an agreement be­tween two parties by which they agree to exchange financial flows denominated in two different currencies with different type of interest rates, one fixed and other floating. Thus, a cur­rency coupon swap enables borrowers (or lenders) to borrow (or lend) in one currency and exchange a structure of interest rate against another-fixed rate against variable rate and vice versa. The exchange can be either of interest coupons only or of interest coupons as well as principal. For example, one may exchange US dollars at fixed rate for French francs at variable rate. These types of swaps are used quite frequently.