Currency Swaps - How do they work?

A 'Currency Swap' is a contract which commits two counterparties to exchange, over an agreed period, two streams of interest payments in different currencies, and at the end of the period to exchange the corresponding principal amounts at an exchange rate agreed to at the start of the contract. The principal amounts are also exchanged at the prevailing spot rate on inception.

The two streams of interest payments can be fixed/fixed, fixed/floating, floating/fixed or floating/floating.

Unlike an interest rate swap, the principal and interest are usually both exchanged in full in a currency swap.

A swap is referred to as 'cross-currency' when it involves an exchange of two streams of interest payments in different currencies, where at least one stream is at a floating rate of interest.

Let's look at the Terminology:

A Currency Swap is one one where two fixed rate interest streams in different currencies are exchanged.

A 'Cross-Currency Coupon Swap' is on where a fixed rate interest stream is exchanged for a floating rate one.

A 'Cross-Currency Basis Swap' is one where two floating rate interest streams in different currencies are exchanged.

In all cases the principal is usually exchanged at inception at the prevailing spot rate and at maturity at an agreed contract rate.

There are other less commonly transacted swaps. They include 'Asset Swaps' which is a currency swap with interest streams backed by cash flows from assets, 'Differential Swaps' which is a cross-currency basis swap that does not involve any exchange of principal, and 'Circus Swaps' which is a combination of a cross currency coupon swap and a single currency coupon swap.

The counterparties to a swap transaction are commonly known as Payers and Receivers. Alternatively the terms Buyers and Sellers are used.

Floating rate interest streams are based on agreed reference rates - commonly 6 Month USD LIBOR (London Interbank Offer Rate). NB AUD floating rates are based on BBSW (Bank Bill Swap Rate).

Fixed Rate interest streams are agreed to at the start of the contract. There are two methods of quoting the fixed rates - the all-in price, or as a swap spread on a benchmark rate.

All-In Prices

A quote for one year swap may be given as 8.00% - 7.85%. This is a two-way price in which the dealer would pay a fixed rate of 7.85%, and would look to receive 8.00% fixed. The dealing spread of 15 basis points represents the dealers profit.

Swap Spreads

This is the convention of quoting the fixed rate in two parts - swap spread and a benchmark interest rate. For example, a GBP/USD cross-currency basis swap might be quoted at +10 - meaning that the swap is between US dollar LIBOR on one hand and sterling LIBOR plus +10 basis points on the other.

The Advantages and Disadvantages of Currency/Cross Currency Swaps

The advantages of currency swap transactions are:
1. They allow active currency exposure management - ie hedging translation risk.
2. They allow aceess to markets with the cheapest source of funds - comparative advantage.

The disadvantages of currency swap transactions are:
1. A default by one counter party leaves a currency exposure.
2. There are higher credit risk issues.
3. They can be expensive to terminate.

Application of Currency Swaps

Currency swaps are regularly used for hedging and arbitrage purposes.

Hedging

Currency swaps can be used as an instrument for eliminated translation risk.
Consider an Australian company that raised AUD 100,000,000 by issuing USD 62,000,000 of USD denominated 3-year bonds paying 6.0% per annum coupons semi-annually when the exchange rate was 0.6200. Each coupon payment is USD 1,860,000, and the principal nrepayment is USD 62,000,000. If the AUD/USD rate falls it will cost more AUD to purchase the USD to make the interest payments, and the principal repayment.

The company could swap from paying fixed USD into paying fixed AUD. If the USD 3-year swap rate was 6.0% per annum and the AUD 3-year swap rate was 6.5% per annum, the company could eliminate its currency risk by receiving the USD rate, and paying the AUD rate.

NB The foreign exchange conversion is done at the spot rate prevailing at the time of the swap. If the swap was done at the time of the issue of the bond when the spot rate was 0.6200, the AUD amount payable at each interest payment date would be a fixed amount of AUD 100,000,000 x 0.065/2 = AUD 3,250,000. The repayment of the USD 62,000,000 principal would be AUD 100,000,000 based on the spot rate of 0.6200.

Arbitrage

Currency swaps can also be used to arbitrage comparative advantage in different markets. Arbitrage opportunities arise because lenders require a larger 'credit premium' for borrowers with poor credit ratings raising funds in weak currencies - than for the same borrowers raising funds in strong currencies.

Consider an Australian company that can raise funds by borrowing in AUD at fixed rate of 15% or issuing Euro denominated bonds at a fixed rate of 9%. By contrast a German Company with a better credit rating can issue AUD Euro bonds at 12% or Euro bonds at 8%. See below:

For AUD Investor

Australian Borrower: 15%
German Borrower: 12%
Interest Differntial: 3%
AUD Equiv: 3%

For Euro Investor

Australian Borrower: 9%
German Borrower: 8%
Interest Differential: 1%
AUD Equiv: 1.15%

Arbitrage Opportunity = 3% - 1.15% = 1.85%

The interest differential reflects the credit premiums required for the less credit worthy borrower.

NB For a more meaningful comparison, the Euro credit premium is translated into Aud percentage points using an AUD/EUR interest conversion factor 1:1.15. The factor is dependent on the interest between the 2 currencies. It is not an exchange rate.

From the example above, it appears the Australian borrower has a comparative advantage in the Euro market, where it faces a premium of only 1.15% against a 3% mark-up in AUD. Similarly the German borrower has a relatively best market in AUD where it can obtain funds 3% below the Australian borrower's rate (15%) - whereas it can only obtain Euro at 1.15% below the Australian borrower's rate (9%).

There to take advantage of the comparative differences, the individual borrowers should raise funds in their relatively best markets, and complete the operation by transacting a currency swap with each other. The arbitrage opportunity of 1.85% is divided between the counterparties within the terms of the swap, accoring to their individual negotiating powers!