Currency swap

Currency swap
What is a Currency Swap?

Table of Contents

What is a currency swap and how does it work?

In the world of finance and trading, a currency swap also goes by the name ‘cross-currency swap’, since you are exchanging one currency for another in the transaction. It is a legal contract between 2 parties, with the pre-stated objective of exchanging the currencies at a future date, at a pre-set rate of exchange.

Typically, global banks are the facilitators of these swaps a.k.a. the middlemen, in currency swap exchanges. It is also possible for global banks to function as counterparties in currency swaps. This is a great way to hedge against their global exposure, particularly as it relates to forex risk.

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What is swap meaning, you may be wondering.

‘In finance, a currency swap is an agreement between 2 counterparties to a forex transaction. They agree to exchange one currency for another, at a specific point in time. The financial instruments can be anything, but the majority of swaps involve forex exchanges.’

What are the benefits of currency swaps?

Currency swaps are universally accepted as a convenient legal contract in finance. These currency swaps allow loans to be redenominated, and they make it easy to understand how one currency must be paid for in terms of another currency.

The benefits of swaps are enjoyed by individuals and companies alike. For one thing, swaps allow greater flexibility to hedge against the attendant risk of cross-currency exchange rates. Plus, there’s the added benefit of locking in a fixed exchange rate for a much longer period of time. That way, you can budget accordingly, and hedge against the uncertainty of volatile markets.

Large multinational corporations routinely make use of currency swaps, given the many advantages they offer. For one thing, swaps make it easy to raise funds in one currency and generate savings in another currency. There are minimal risks associated with swap trading. Additionally, currency swaps are highly liquid, and both parties to the transaction are able to settle on an agreement at any point during the lifespan of the currency swap transaction.

Parties to a currency swap are able to terminate the financial transaction prior to its designated date, through a negotiated settlement.

Swap trading: practical examples

Years ago, swap trading was conducted expressly to bypass government-sanctioned exchange rate controls. Nowadays, currency swaps are performed as part of a hedging strategy against FX fluctuations. Swaps are also used to lower the interest rate exposure of parties to the transaction, or simply to obtain cheaper debt.

As an example, assume that a US-based corporation ABC wants to expand into the UK. At the same time, assume that a UK-based corporation DEF wants to enter the US market. These international companies operate in the US and the UK respectively, and as such are unlikely to be offered competitive loans by banks and financial institutions.

As a case in point, UK banking institutions offer company DEF a loan at 12%. US banking institutions may offer company ABC loans at 13%. However, both of these companies may have a competitive advantage in the domestic markets where they can get loans at 8%. The next step is where things get really interesting!

Company ABC in the US could swap loans with company DEF in the UK at 8%. Both of these companies could effectively pay one another’s interest obligations on their debt. In the case of loan differentials, currency swaps are still possible. Companies ABC and DEF simply negotiate a formula that reflects their respective swap trading obligations with one another.

There is another option available. Company ABC and company DEF could tackle the forex swap by issuing bonds at underlying interest rates. These companies would then deliver the bonds to the swap bank. The swap bank will then switch them over to one another.

In this example, company ABC will have assets in the United Kingdom, while company DEF will have assets in the United States. The interest generated from company ABC will be paid through the swap bank and delivered to company DEF, and vice versa. This is an example of a currency swap with different interest rates in action.

At maturity, each of the companies will pay the principal amount to the swap bank, and they will receive the original principal in return. In both cases, company ABC, and company DEF has the forex they desire, at a much cheaper interest rate, while also protecting themselves against forex risk.

Understanding forex Swaps

A forex swap in online FX trading is a rollover interest that is earned or paid for holding your positions overnight. The charges levied on these swaps depend upon the interest rates of the currencies in the transaction. The swap charge is dependent on whether you are short or long on the currency pair.

Currency traders who open/close trades within the same day a.k.a. day traders are not subject to swap interest. High-yield (positive) currencies include the AUD and the NZD, while low-yield (negative) currencies include the EUR and JPY. Generally, your swap interest will be positive if you exchange a high-yield currency with a low-yield currency, but it is possible for the reverse situation to occur.

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Frequently Asked Questions about currency swap trading

  • What is the point of a currency swap?

    When businesses and institutions participate in currency swaps, the primary reason for this is to hedge against forex risk. Another reason for currency swaps is to gain access to cheaper financing. Typically, a high-yield currency such as the AUD is purchased, while a low-yield currency such as the JPY is sold.

    provided the forex price movement in the currency pair -AUD/JPY – is flat, or advantageous to the forex trader, the pair can be held while simultaneously collecting the swap or the difference in interest rates between the two currencies.

     
  • What is the biggest benefit of currency swaps for investors?

    There are several reasons why investors engage in currency swaps, notably income generation. However, the biggest benefit of currency swaps for retail investors is hedging against volatility in the forex markets. When a currency swap is negotiated, an investor can substantially reduce volatility in their foreign holdings.

    This improves the risk/return profile and substantially decreases volatility in the portfolio. The ever-changing nature of forex rates naturally lends to increased interest in currency swaps as a means of mitigating against wild price swings. This can shore up a portfolio, and protect against losses.

     
  • What are the main risks of currency swaps?

    Currency swaps don’t always go the way traders expect. For example, it is possible for a forex pair to reverse direction, thereby negating the intended effects of the forex swap to begin with. If an investor is hoping to hedge against the AUD/JPY pair, but forex movements make the exchange rate unprofitable, then the swap is no longer helpful. With currency swaps, businesses are subject to interest rate risk and credit risk. This is particularly true when the swaps take place over a long period of time.

     
  • What is the purpose of a currency swap?

    In the case of swaps being made by businesses and institutions, the reason currency swaps are done is typical as a hedge, or as a way to get cheaper financing. In the investing world, a currency swap might be sought after by buying a high-yielding currency such as the Australian dollar, while simultaneously selling a low yielding currency like the Japanese Yen. So long as the movement in the pair is flat or advantageous to the trader, they can continue holding the pair while also collecting the swap or the difference in interest rates between the two currencies.

     
  • What’s the greatest advantage of currency swaps for investors?

    While using a currency swap as a way to generate income can be useful, the greatest advantage of a currency swap for retail investors is the ability to hedge against volatility in the currency markets. With a currency swap an investor can reduce the volatility in their overseas holdings, thus improving their risk-return profile and smoothing out the ups and downs in their portfolio. Because currency rates are always changing currency swaps can help to smooth out profits and losses in any portfolio.

     
  • What are the potential downsides to currency swaps?

    There are a few negatives that can also be associated with currency swaps. In the case of an investor hedging their position, any positive movement in the currency will be muted in the results of the investment because the hedge is protecting from volatility in both directions. Those holding a position to collect the swap (such as AUD/JPY) could get wiped out by a sudden adverse movement in the currency pair. In the case of businesses doing swaps, there is a credit and interest rate risk, particularly with swaps that stretch over several years.

     

Last word on currency swap transactions

A currency swap is designed to incentivize traders to place long-term trades in the forex market. It’s really important to have a thorough understanding of the financial markets, and particularly currency pairs when negotiating swaps. Slight differences in cross-currency exchange rates and interest rates can have an outsized impact on the profitability of your forex trading activity. In essence, the currency swap meaning to help investors smooth out price fluctuations to generate predictable flows.

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