Question

What is the relationship between cash flows among the three parties in a currency swap. Describe how Firm A, Firm B, and the swap bank pay and receive cash flows.

Answer 1

The following is the introduction to currency swap and swap bank:

• A currency swap involves the exchange of interest—and sometimes of principal—in one currency for the same in another currency.
• Companies doing business abroad often use currency swaps to get more favorable loan rates in the local currency than if they borrowed money from a local bank known as swap bank.
• Considered to be a foreign exchange transaction, currency swaps are not required by law to be shown on a company's balance sheet.
• Interest rate variations for currency swaps include fixed rate to fixed rate, floating rate to floating rate, or fixed rate to floating rate.

The example will help you understand how company A, company B, and the swap bank pay and receive cash flows:

Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan. On trade date, Company A exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP (equivalent to 1.35 GBP/USD).

During the life of the transaction, Company A pays a fixed rate in GBP to Company B in return for USD six-month LIBOR. The USD interest is calculated on $100 million USD, while the GBP interest payments are computed on the 74 million pound amount.

At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100 million USD and Company B receives 74 million pounds.

Company A and B might engage in such a deal for a number of reasons. One possible reason is the company with US cash needs British pounds to fund a new operation in Britain, and the British company needs funds for an operation in the US. The two firms seek each other and come to an agreement where they both get the cash they want without having to go to a bank to get loan, which would increase their debt load. As mentioned, currency swaps don't need to appear on a company's balance sheet, where as taking a loan would.

Having the exchange rate locked in lets both parties know what they will receive and what they will pay back at the end of the agreement. While both parties agree to this, one may end up better off. Assume in the scenario above that shortly after the agreement the the USD starts to fall to a rate of 0.65 USD/GBP. In this case, Company B be would have been able to receive $100 million USD for only $65 million GBP had they waited a bit longer on making an agreement, but instead they locked in at $74 million GBP.

While the notional amounts are locked in are and not subject to exchange rate risk, the parties are still subject to opportunity costs/gains in that ever changing exchange rates (or interest rates, in the case of a floating rate) could mean one party is paying or more less than they need to based on current market rates.