Contents

Structure [ edit ]

Currency swaps are over-the-counter derivatives. and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal. [ 1 ] There are three different ways in which currency swaps can exchange loans:

1. The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap. [ 3 ]
2. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap ) because they are denominated in different currencies. As each party effectively borrows on the other’s behalf, this type of swap is also known as a back-to-back loan. [ 3 ]
3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross currency swap. [ 4 ]

Uses [ edit ]

Currency swaps have three main uses:

• To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan). [ 3 ]
• To hedge against (reduce exposure to) exchange rate fluctuations. [ 3 ]
• To defend against financial turmoil by allowing a country beset by a liquidity crisis to borrow money from others with its own currency.

Hedging example [ edit ]

For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging either of the following:

• If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company’s finance cost is in that company’s domestic currency.
• Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap .

Examples [ edit ]

Suppose the British Petroleum Company plans to issue five-year bonds worth £100 million at 7.5% interest, but actually needs an equivalent amount in dollars, $150 million (current $/£ rate is $1.50/£), to finance its new refining facility in the U.S. Also, suppose that the Piper Shoe Company, a U. S. company, plans to issue $150 million in bonds at 10%, with a maturity of five years, but it really needs £100 million to set up its distribution center in London. To meet each other’s needs, suppose that both companies go to a swap bank that sets up the following agreements:

• Agreement 1:

The British Petroleum Company will issue 5-year £100 million bonds paying 7.5% interest. It will then deliver the £100 million to the swap bank who will pass it on to the U.S. Piper Company to finance the construction of its British distribution center. The Piper Company will issue 5-year $150 million bonds. The Piper Company will then pass the $150 million to swap bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its U.S. refinery.

• Agreement 2:

The British company, with its U.S. asset (refinery), will pay the 10% interest on $150 million ($15 million) to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. The American company, with its British asset (distribution center), will pay the 7.5% interest on £100 million ((.075)( £100m) = £7.5 million), to the swap bank who will pass it on to the British company so it can pay its British bondholders.

• Agreement 3:

At maturity, the British company will pay $150 million to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. At maturity, the American company will pay £100 million to the swap bank who will pass it on to the British company so it can pay its British bondholders.

Abuses [ edit ]

In the 1990s Goldman Sachs and other US banks offered Mexico, currency swaps and loans using Mexican oil reserves as collateral and as a means of payment.

The collateral of Mexican oil was valued at $23.00 per barrel.

In May 2011, Charles Munger of Berkshire Hathaway Inc. accused international investment banks of facilitating market abuse by national governments. For example, Goldman Sachs helped Greece raise $1 billion of off- balance-sheet funding in 2002 through a currency swap, allowing the government to hide debt. [ 5 ] Greece had previously succeeded in getting clearance to join the euro on 1 January 2001, in time for the physical launch in 2002, by faking its deficit figures. [ 6 ]

History [ edit ]

Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling. [ 7 ] While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage .

The first formal currency swap, as opposed to the then used parallel loans structure, was transacted by Citicorp International Bank for a $US100,000,000 10 year US Dollar Sterling swap between Mobil Oil Corporation and General Electric Corporation Ltd (UK). The concept of the interest rate swap was developed by the Citicorp International Swap unit but cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of $210 million and a term of over ten years. [ 8 ]

During the global financial crisis of 2008. the currency swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central bank of a developed [ 9 ] or stable emerging [ 10 ] economy agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps is to provide liquidity in U.S. dollars to overseas markets. [ 11 ] While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term. [ 12 ]

South Korea and Indonesia signed a won-rupiah currency swap deal worth US$10 billion in October, 2013. The two nations can exchange up to 10.7 trillion won or 115 trillion rupiah for three years. The three-year currency swap could be renewed if both sides agree at the time of expiration. It is anticipated to promote bilateral trade and strengthen financial cooperation for the economic development of the two countries. The arrangement also ensures the settlement of trade in local currency between the two countries even in times of financial stress to support regional financial stability. As of 2013, South Korea imported goods worth $13.2 billion from Indonesia, while its exports reached $11.6 billion.