Question

Describe in detail how a currency swap works. Be sure to discuss who might enter such an agreement, why they might do so and the mechanics of settlement.

Answer 1

A currency swap is a swap in which two parties exchange the principal amount of loan and the interest in one currency for principal and interest amount in another currency. At the point of inception of the swap the equivalent principal amounts are exchanged on the basis of the spot rate.

A currency swap can only involve exchange of principal or exchange of interest rate. In case of exchange of principal the principal amounts create an implied exchange rate. In case of exchange of interest rates there can be exchange of fixed rate to floating rate, floating rate to floating rate and fixed rate to fixed rate.

The main purpose of currency swaps is to obtain a foreign currency loan at a better interest rate compared to interest rate that would have been paid if the loan is taken directly in the foreign market.

To illustrate the concept let me make use of a hypothetical example. Suppose that an American company can borrow in USA at the rate of 6%. But the company is expanding its operations in Japan and wants loans to denominated in Japanese Yen (JPY) and not U.S. dollars (USD). The prevailing rate in Japan is 9%. Also there is a Japanese company who is looking to finance its American operations and the applicable direct borrowing rate for the Japanese company in USA is 11%. Its borrowing rate in Japan is 8%. In this case the U.S. Company and the Japanese company will stand to gain by entering into a fixed to fixed currency swap. The U.S. Company will borrow USD at 6% and the funds will be lent to the Japanese Company at 6%. The Japanese Company will borrow JPY at 8% and will lent to the U.S. Company.