CFM13420 - Understanding corporate finance: derivatives: currency swaps and FX swaps

Currency swaps

Another way of hedging exchange risks is by the use of currency swaps. You are most likely to see currency swaps either between banks, or between a member of a large group of companies and a bank, usually hedging substantial borrowing or lending.

A currency swap is similar to an interest rate swap (CFM13320), in that the parties make payments for an agreed period computing by applying a rate of interest, whether fixed or floating, to defined notional principal amounts. But a currency swap has an extra element, because two different currencies are involved. Accordingly the swap will require the parties to exchange the two notional currency amounts on maturity of the swap. This is not necessary with a simple interest rate swap, because the two legs work by reference to the same amount of a single currency. One of those currencies may be sterling: equally, a UK company might enter into a swap involving two different non-sterling currencies, for example the US dollar and the Japanese yen.

All currency swaps have two basic components:

• an exchange of amounts (periodic payments) computed by applying a rate of interest to notional principal amounts over the duration of the swap
• an exchange of the notional principal amounts of the currencies at the end.

The notional principal amounts in each currency are normally set by reference to the spot rate of exchange at the time the parties enter into the contract. There may also be an initial exchange of currencies, but this is optional.

See the example at CFM13430.

Normally the swap is designed to hedge currency risk only, so the periodic payments are set by reference to floating interest rates, for instance 6-month USD LIBOR and 6-month sterling LIBOR plus or minus a margin. If a company also wished to, say, pay a fixed interest rate, it would normally enter into a separate sterling interest rate swap, which would allow more flexibility and probably achieve a better rate through use of simpler instruments. But, more exotic instruments such as floating rate USD versus fixed rate sterling do exist.

FX Swaps

There is also a product called an FX swap, which is in essence a currency forward contract, supplemented by an initial of currencies at the spot exchange rate. There are no periodic payments; the interest rate differential is reflected in the difference between spot and forward rates. On maturity the parties may enter into a further similar FX swap for the same ‘foreign’ currency principal to continue the hedge. The final exchanges of currencies on the first FX swap may be netted against the initial spot exchange of currencies, leaving only a single net payment to be made, in the ‘home’ currency. (The ‘foreign’ currency is risk that is hedged and the ‘home’ currency the one it is hedged into.) Such FX swaps are widely used. Although they are short term instruments, the can be used to hedge longer term exposures, by ‘rolling them over’ on maturity. It is easy to vary the foreign currency amount hedged as necessary, on maturity of a contract, by entering into a new contract for a greater or smaller foreign currency amount, as the exposure increases or falls.