A currency swap is a “contract to exchange at an agreed future date principal amounts in two different currencies at a conversion rate agreed at the outset”.
During the term of the contract the parties exchange interest, on an agreed basis, calculated on the principal amounts.
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A currency swap is a legal agreement between two parties to exchange the principal and interest rate obligations, or receipts, in different currencies.
The transaction involves two counter-parties who exchange specific amounts of two currencies at the outset, and repay them over time according to a predetermined rule that reflects both the interest payment and the amortisation of the principal amount.
A currency swap is an agreement to exchange fixed or floating rate payments in one currency for fixed or floating payments in a second currency plus an exchange of the principal currency amounts.
Currency swap allows a customer to re-denominate a loan from one currency to another.
The re-denomination from one currency to another currency is done to lower the borrowing cost for debt and to hedge exchange risk.
The concept behind is to match the difference between the spot and forward rate of any currency over a specified period of time.
Usually, banks with a global presence act as intermediaries in swap transactions, helping to being together the two parties. Sometimes, banks themselves may become counter-parties to the swap deal, and try to offset the risk they take by entering into an offsetting swap deal.
Alternatively, banks can hedge themselves by taking positions in the futures markets.
Types of Currency Swaps
1. Fixed to Fixed Currency Swap:
In this form of swap, it may involve exchanging fixed interest payments on a loan in one currency for fixed interest payments on an equivalent loan in another currency. It is not necessary that the actual principal be swapped. Sometime, an alternative currency can be exchanged at spot into desired currency, however the principal amounts are always re-exchanged at the maturity of the swap.
2. Fixed to Floating Cross Currency Swap:
In this form of swap, fixed rate obligations in one currency are swapped for floating rate obligations in another currency. For example, US dollars at fixed rates can be swapped against sterling with LIBOR + floating rate.
Stages in Currency Swap
The currency swaps involve an exchange of liabilities between currencies.
A currency swap can consist of three stages:
1. A spot exchange of principal – this forms part of the swap agreement as a similar effect can be obtained by using the spot foreign exchange market.
2. Continuing exchange of interest payments during the terms of the swap – this represents a series of forward foreign exchange contracts during the term of the swap contract. The contract is typically fixed at the same exchange rate as the spot rate used at the outset of the swap.
3. Re-exchange of principal on maturity.
In a currency swap the principal sum is usually exchanged in one of the following manner:
(i) At the start
(ii) At a combination of start and end
(iii) At the end