Currency swap

A currency swap (or a cross currency swap) is a foreign exchange derivative between two institutions to exchange the principal and/or interest payments of a loan in one currency for equivalent amounts, in net present value terms, in another currency. Currency swaps are motivated by comparative advantage.^[1] A currency swap should be distinguished from interest rate swap, for in currency swap, both principal and interest of loan is exchanged from one party to another party for mutual benefits.^[1][2]

Currency swaps are over-the-counter (OTC) derivatives.

Structure

There are multiple 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 or futures contract. 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 a 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. Other structures include swapping only interest payment cash flows on loans of the same size and term, with or without fx options at the maturity of the trade. Again, as these are cross-currency swaps, the exchanged cash flows are in different denominations and so are not netted.^[4]

Uses

Currency swaps have many uses, some are itemized:

• 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) forward 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, see swap lines.

Additionally, cross-currency swaps are an integral component in modern financial markets as they are the bridge needed for assessment of yields on a standardised USD basis. For this reason there are also used as the construction tool in creating collateralized discount curves for valuing a future cashflow in a given currency but collateralized with another currency. Given the importance of collateral to the financial system at large, cross-currency swaps are important as a hedging instrument to insure against material collateral mismatches and devaluation,.^[5]

Hedging example

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

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 paying 10% interest. 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.

Variations

There are two main types of cross currency swaps: floating-for-floating and fixed-for-floating.

Floating-for-floating CCS

In a floating-for-floating cross currency swap, the interest rate on both legs are floating rates. Such swaps are also called cross currency basis swap. Floating-for-floating swaps are commonly used for major currency pairs, such as EUR/USD and USD/JPY.

Fixed-for-floating CCS

In a fixed-for-floating cross currency swap, the interest rate on one leg is floating, and the interest rate on the other leg is fixed. Such swaps are usually used for a minor currency against USD.

Mark-to-market CCS

In a regular cross currency, the notional amounts of both legs are constant during the life of the swap. However, in a mark-to-market cross currency swap, the notional amount of one of the legs is subject to adjustment while the notional amount of the other leg remains constant. The market-to-market variation is paid or received.^[6]

Non-deliverable CCS

Non-deliverable CCS, usually abbreviated as NDCCS or simply NDS, are very similar to a regular CCS, except that payments in one of the currencies are settled in another currency using the prevailing FX spot rate. NDS are usually used in emerging markets where the currency is thinly traded, subject to exchange restrictions, or even non-convertible.^[7]

Valuation

It is well recognized^[8][9] that traditional "textbook" theory does not price cross currency (basis) swaps correctly, because it assumes the funding cost in each currency to be equal to its floating rate, thus always giving a zero cross currency spread. This is clearly contrary to what is observed in the market. In reality, market participants have different levels of access to funds in different currencies and therefore their funding costs are not always equal to LIBOR.

An approach to work around this is to select one currency as the funding currency (e.g. USD), and select one curve in this currency as the discount curve (e.g. USD interest rate swap curve against 3M LIBOR). Cashflows in the funding currency are discounted on this curve. Cashflows in any other currency are first swapped into the funding currency via a cross currency swap and then discounted.^[9]

Abuses

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."^[10] 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.^[11]

History

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.^[12] 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.^[13]

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^[14] or stable emerging^[15] 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."^[16] 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.^[17]

The People's Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, Belarus, Brazil, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, South Korea, United Kingdom and Uzbekistan that perform a similar function to central bank liquidity swaps.^{[18][19][20][21][22]}

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.

See also

• Interest rate swap
• Foreign exchange swap

References

External links

• Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial Markets Group
• Bank of England announces People’s Bank of China swap line, June 2013
• People’s Bank of China's second-biggest swap line with European Central Bank, October 2013
• Reuters article