Question

Use real or hypothetical examples as a way to illustrate your explanation:

- Currency Swaps: mechanism, benefits, costs

Answer 1

currency swap

A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency.At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.During the length of the swap each party pays the interest on the swapped principal loan amount.At the end of the swap the principal amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate such as the rate of the original exchange of principals. Using the original rate would remove transaction risk on the swap.Currency swaps are used to obtain foreign currency loans at a better interest rate than a company could obtain by borrowing directly in a foreign market or as a method of hedging transaction risk on foreign currency loans which it has already taken out.

Benefits

• Borrowing at Lower Cost: Swap facilitates borrowings at lower cost.
• Access to New Financial Markets.
• Hedging of Risk.

costs on swap

Currency swaps exists due to the difference in the interest rates of the currencies. Depending on the currency pair, swaps can either be negative or positive. The cost of it (or potential gain) depends on the currencies involved.

Example : one party receives $10 million British pounds (GBP), while the other receives $14 million U.S. dollars (USD). This implies a GBP/USD exchange rate of 1.4. At the end of the agreement, they will swap again using the same exchange rate, closing out the deal.