Currency swap

Introduction

Currency swap is an agreement between two counterparties to exchange series of

payments denominated in two different currencies and exchange of underlying principal.
Currency swaps enable interest rate exposure in one currency to be swapped with interest rate
exposure in another (favorable) currency. Swaps can be looked at as a portfolio of forward rate
agreements or portfolio of two bonds. It is worthwhile to note that unlike interest rate swaps, the
cash flows are not netted and currency swaps involve exchange of underlying notional amount
(principal) at the beginning and at the end of the swap. Swaps are over-the-counter (OTC)
instruments i.e. they are not traded on exchanges. ISDA (International Swaps and Derivatives
Association) works towards making swaps market efficient and safe. After the mortgage crisis of
2007, there has been a discussion on making swaps exchanges traded products.

Types of Currency Swap

A currency swap may include exchange of only principal (like forwards agreement), or
interest rate and principal or only interest rate. Based on this criterion swaps can be classified
as

1. Swaps with exchange of both principal & interest payments

2. Swaps with exchange of principal payments only
3. Swaps with exchange of interest payment only

First type of swap is the most common swap. One may prefer futures or forwards contract to
second type of swap if the term of swap is short as it is easier and cheaper to find counterparty.
For longer terms, spreads could be very wide for other derivatives and getting into swaps could
be efficient.

A swap always has two legs. The two legs can be priced using either floating or fixed rates.
Swaps can also be classified based on this criterion as follows

1. Pay fix rate; receive fix rate

2. Pay fix rate; receive floating rate
3. Pay floating rate; receive fix rate
4. Pay floating rate; receive floating rate
Example,

Let us assume that the borrowing rates for two companies GM Motors and Qantas Airways in
two currencies USD and AUD are as follows

Company USD AUD

GM Motors 5% 12.6%
Qantas Airways 7% 13%

General Motors is more creditworthy (at least at the time this diagram was drawn!) that Qantas
Airways and hence it gets lower spread on the interest rate. Now let us assume that GM Motors
wants to fund its expansionary plans in Australia and so does Qantas in USA. Suppose GM
Motors needs 20MM AUD and Qantas Airways need 12MM USD. GM would want to borrow in
US markets and Qantas would want to borrow in Australian market. Thus both the parties can
get into a currency swap as shown in the diagram above and achieve their objectives. Note the
spread earned by financial institution. As is visible in the diagram, after both parties get into
swap, GM ends borrowing AUD at 11.9% and Qantas ends up borrowing USD at 6.3%. When
these numbers are compared with the numbers in the table, we observe that both parties benefit
from entering into the swap. Note that with the swap there is a counterparty risk to both
corporations. Financial institution makes a gain of USD 156,000 and incurs a loss of AUD
220,000. The financial institution can lock in its profit by entering into forward contract to buy
AUD 220,000 every year through the life of swap to eliminate foreign exchange risk.

Cost

Swaps are costly instruments to get into compared to exchange traded futures and
option or Forward OTC contracts as it is difficult to find counterparty and get into an agreement
with them. Usually investment banks act as intermediaries. Corporations approach investment
banks for swaps and investment banks charge corporations by applying spread to the swap
rate. GM Motors and Qantas Airways example mentioned above explains this in detail. Added
counterparty risk is also a cost for a corporation that executes a swap. However, this risk is less
probable compared to exchange rate risk. Moreover, a corporation can buy insurance against
counterparty default risk in the form of credit default swap increasing the cost of overall
transaction further.

Investment banks usually have a dedicated swaps desk to advise corporations on the
swaps and to facilitate the swap deal.

Pricing

A swap can be looked at as a combination of an asset and a liability which constitute the
two legs of the swap. Basic principal behind valuation of the swap at time zero is that the NPV
of asset must equal NPV of liability. Value of swap at any time in future is the difference
between asset leg and the liability leg. Thus at time zero value of a swap must be zero.

For the pricing purpose, two legs of the swap can be viewed as two positions on two
bonds denominated in two different currencies. One position is short and the other is long. Thus
the value of the swap is given by

Vswap = BD – S0*BF

where,

Vswap = Value of Swap when domestic currency is paid and foreign currency is received
BD = Value of bond denominated in domestic currency
S0 = Spot Exchange Rate
BF = Value of bond denominated in foreign currency

Thus one needs term structure of interest rates in both currencies, LIBOR and spot
exchange rate to find out the value of the swap. Term structure of interest rate can be obtained
by regression analysis or by polynomial spline using treasury yields and no arbitrage condition.

Example:

Let us find out the notional value of second leg of swap if a corporation wants to enter into USD
1MM 3 year swap against JPY.

Let us assume that spot rate USD/JPY is 100

And the term structure of interest rate in USD and JPY is

USD Rates JPY Rates

1 Year 4.00 1 Year 1.00

2 Year 4.50 2 Year 1.50

3 Year 5.50 3 Year 1.90

Suppose a corporation wants to get into three year currency swap such that it receives USD
fixed at 6.50% and pays JPY fixed at 1.50% one every year.

Notional Amounts are USD 1MM and JPY 100MM.

Value of the swap at time zero will be zero. Thus using the goal seek function in the excel we
conclude that notional amount of JPY should be 102,192,596.04 MM.

USD Cash Discount

Inflow Factor Present Value
1Y 65,000.00 0.961538462 62,500.00
2Y 65,000.00 0.915729951 59,522.45
3Y 1,065,000.00 0.851613664 906,968.55
1,028,991.00

Discount
JPY Cash Inflow Factor Present Value
1Y 1,532,888.94 0.99009901 1,517,711.82
2Y 1,532,888.94 0.970661749 1,487,916.66
3Y 103,725,484.98 0.963056201 99,893,471.52
102,899,100.00
Notional
Amount (In
in JPY 102,192,596.04 1,028,991.0000 USD)

After first payment interest rates may change. In such a case discount factors will
change. One has to perform similar calculations and the value of the swap is the difference
between two legs.

Currency swap could also be decomposed into a series of forward contracts. Each of the
exchange of cash flow is a forward contract including the exchange of principal.
Hedging

Primary use of currency swaps is hedging against exchange rate risk. As we all know,
international trade is an integral part of today’s economy. Economies are integrating into one
single global economy. Domestic investors invest in foreign countries for the purpose of
diversification or if they perceive that rate of returns would be higher in foreign countries. These
foreign assets may yield a higher return however due to exchange rates the gains may not be of
the same magnitude in the home country of the investor. Moreover, different corporations have
global operations and may need funds denominated in different currencies. Most of the times
such funds are required to be borrowed and not all corporations can have access to foreign debt
markets. Thus, as in the example stated above, a corporation may have access to cheaper debt
in its home country than in a foreign country where its creditworthiness is not recognized. But a
corporation cannot borrow foreign currency in its home country. Companies should focus on the
main business they are in and take steps to minimize risks arising from interest rates and
exchange rates. All these scenarios give rise to the need of hedging. Swaps could be used to
fully hedge the risk exposure or to partially hedge the risk exposure.

However, there are arguments against hedging too. By hedging corporations definitely
reduce their risk however at some monetary cost. If the adverse condition for which a currency
swap is held (excess depreciation of the currency) does not occur then a corporation may even
lose profit that it otherwise would have gained. Moreover, the shareholders can diversify their
holdings themselves and a corporation need not do that for its shareholders. Corporation may
pass the excess cost of risk even materializing to its consumer rather than hedging it itself. If the
competitors are not hedging then corporation may not do it either. Explaining a situation where
there is a loss on hedge but gain on underlying could be difficult.