Question

3) Describe (by using a hypothetical example) a typical currency swap transaction. Please be sure to explain the potential benefits of a typical currency swap transaction to both parties and construct a diagram, which explains the detailed mechanics of such transaction (including all the relevant cash flows in both currencies).

Answer 1

A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either act on their own or as an agent for a non-financial corporation. The purpose of a currency swap is to hedge exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.

Example of Currency Swap

Company A is a US-based company that is planning to expand its operations in Europe. Company A requires €850,000 to finance its European expansion.

On the other hand, Company B is a German company that operates in the United States. Company B wants to acquire a company in the United States to diversify its business. The acquisition deal requires US$1 million in financing.

Neither Company A or Company B holds enough cash to finance their respective projects. Thus, both companies will seek to obtain the necessary funds through debt financing. Company A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at a lower interest rate) and then enter into the currency swap agreement with each other.

The currency swap between Company A and Company B can be designed in the following manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate of 3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating interest rate of 6-month LIBOR. The companies decide to create a swap agreement with each other.

According to the agreement, Company A and Company B must exchange the principal amounts ($1 million and €850,000) at the beginning of the transaction. In addition, the parties must exchange the interest payments semi-annually.

Company A must pay Company B the floating rate interest payments denominated in euros, while Company B will pay Company A the fixed interest rate payments in US dollars. On the maturity date, the companies will exchange back the principal amounts at the same rate ($1 = €0.85).

Benefits

• Currently swaps enable corporate to exploit their comparative advantage in raising funds in one currency to obtain savings in other currencies.
• Currency swaps permit corporate to switch their loans from a particular currency to another depending on their expectations of the future movement of the currency and interest rates.
• It offers flexibility to corporate seeking to hedge the risk associated with a particular currency.
• A company no longer has to live with a bad decision, if it has selected a wrong currency for its overseas funding operations, a currency swap can undo the damage.
• Currency swap can be used to lock into exchange rates for a longer period and it do not require monitoring and reviewing.