A currency swap in its simplest form involves the exchange of principal and interest payments in one currency for principal and interest payments in another currency. The amounts involved are usually of equal magnitude and they are exchanged with interest at the beginning and the end of the life of the swap. The following currency swaps are covered here:
• Simple currency swap.
• Comparative advantage currency swap.
• Variations on the theme.
Simple currency swap
Our first example of a swap is a simple one (see Figure 7; assumption: starting exchange rate = GBP / USD 1.5).
The UK financial intermediary company has all its assets in UK pounds, but has GBP 100 million of its liabilities in USD (2-year 10% pa fixed bond issue in USD = USD 150 million). In a similar fashion, a US financial intermediary has all its assets in USD but has USD 150 million of GBP liabilities (2-year 10% pa fixed GBP-denominated bond = GBP 100 million). Interest on both bonds is payable annually.
After a year the UK intermediary becomes concerned that the GBP will depreciate in relation to the USD and it will have to service the debt (interest and principal) with more pounds in the future. At the same time the US intermediary becomes concerned that the USD is about to depreciate in relation to the GBP, and that it will have to service its UK pound debt (interest and principal) with depreciated dollars.
Figure 7: example of currency swap
There is always a smart banker that will spot this "opposing currency risk condition". He proposes the deal as illustrated in Figure 7, and takes a "small" turn in one of the legs (which we ignore here for the sake of simplicity).
The swap is done for principal and interest and the relevant amounts change hands at T+lyear. At T+2 (expiry of the swap and the bonds) the amounts plus interest are exchanged again in order for the debtors to repay the creditors the principal plus interest amounts.
If at T+2 the exchange rate is GBP / USD 1.4, i.e. the GBP has depreciated (less USD per GBP or more GBP per dollar: 1 / 1.4 = 0.71429 GBP per USD, compared with 1 / 1.5 = 0.66667 GBP per USD), the UK company is better off than it would have been in the absence of the swap, with the position of the US company being the converse. In the absence of the swap the UK company would have had to buy USD 165 million for GBP 117.86 million (1 / 1.4 x USD 150 million),compared with GBP 110 million it paid. The US company would have been better of had the swap not been undertaken: it would have bought GBP 110 for USD 154 million (1.4 x GBP 110 million), compared with USD 165 million it paid.
The above is an example where the currency swap transmutes liabilities from one currency to another, with the purpose of managing currency risk. Another example is where a comparative advantage exists. This follows.
Comparative advantage currency swap
The second example is more realistic Use is illustrated in Figure 8.
Figure 8: example of currency swap
Wants / needs:
A UK company (UKCO) wants to borrow USD 150 million at a floating rate for 10 years in order to make an investment in the US. A German company wants to raise GBP 100 million for 10 years at a fixed rate for investment in the UK. The exchange rate is GBP / USD 1.5.
The following terms are available to them:
• UKCO: USD 150 million at LIBOR + 0.75%
• GERCO: GBP 100 million at 8.5% fixed.
Prelude to swap:
Their banker (they happen to have the same bank as their advisor) advises them that they should not borrow on these terms, but rather as follows which they are able to:
• UKCO: borrow GBP 100 million at a fixed rate of 8% for 10 years
• GERCO: borrow USD 150 million at LIBOR + 0.25%
and that they simultaneously undertake to swap the principal and the obligations (interest is payable every six months). It is evident that if they exchange debt obligations, their wants will be satisfied and they will be borrowing at a lower rate.
A summary of the borrowing terms is given in Table 4.
Wants to borrow in:
Actually borrows in:
LIBOR + 0.75
Fixed rate 8% pa
LIBOR + 0.25
Fixed rate 8.5% pa
Table 4: Example of comparative advantage currency swap: interest payments
Each party has an advantage in a market compared with the other party: UKCO in the GBP market and
GERCO in the USD market.
Borrowing and the swap:
UKCO and GERCO see the advantages, accept the terms, borrow as advised, and the swap takes place. Each is able to make their desired investment as follows:
• UKCO: investment of USD 150 million
• GERCO: investment of GBP 100 million.
The periodic exchange of interest:
The following cash flows take place over the period of 10 years (interest is payable every six months):
- Pay: 8% fixed rate on GBP 100m (to holders of securities)
- Receive: 8% fixed rate on GBP 100m (from GERCO)
- Pay: LIBOR + 0.25% on USD 150m (to GERCO)
- Pay: LIBOR + 0.25% on USD 150m (to holders of securities)
- Receive: LIBOR + 0.25% on USD 150m (from UKCO)
- Pay: 8% fixed rate on GBP 100m (to UKCO).
Exchange of principal on expiry of contract:
At expiry of the swap the principal amounts are exchanged as follows:
• UKCO: USD 150 million to GERCO
• GERCO: GBP 100 million to UKCO.
They are able to repay the holders of the securities they issued.
The net result of the swap is that UKCO gets to borrow in its preferred habitat: USD 150 million at LIBOR, but it borrows at a cheaper rate (i.e. LIBOR + 0.25% as opposed to LIBOR + 0.75%). Similarly, GERCO borrows where it wanted to (GBP 100 million in the UK at a fixed rate), but also at a cheaper rate (8.0% fixed as opposed to 8.5% fixed).
It is to be noted that the interposition of the bank was left out in the numbers. It will be evident that the savings by each party allow for the banker to take a "healthy" turn. The banker was excluded because of the extra arrows that would have rendered the illustrations untidy.
Variations on the theme
There are variations on the main theme of currency swaps, but not as many as in the case of interest rate swaps. One of them is the cross currency swap (also called currency coupon swap). It involves the exchange of a floating rate in one currency for a fixed rate in another currency. This is essentially a hybrid of the currency swap and the plain vanilla interest rate swap.
Another is the differential swap (also termed the diff swap), which involves the exchange of a floating rate in the domestic currency for a floating rate in a foreign currency. Both payments are referenced against a domestic notional amount.