Fixed-Rate Currency Swaps
A fixed rate currency swap consists of the exchange between two counter-parties of fixed rate interest in one currency in return for fixed rate interest in another currency. Following are the main steps to all currency swaps:
- Initial Exchange for the Principal: The counter-parties exchange the principal amounts on the commencement of the swap at an agreed rate of exchange. Although this rate is usually based on the spot exchange rate, a forward rate set in advance of the swap commencement date can also be used. This initial exchange may be on a notional basis of alternatively a physical exchange. The sole importance of the initial exchange on being either on physical or notional basis, is to establish the quantum of the respective principal amounts for the purpose of (i) calculating he ongoing payments of interest and (ii) the re-exchange of principal amounts under the swap.
- Ongoing Exchanges of Interest: Once the principal amounts are established, the counter-parties exchange interest payments based on the outstanding principal amounts at the respective fixed interest rates agreed at the outset of the transaction.
- Re-exchange of the Principal Amounts: On the maturity date the counter-parties re-exchange the principal amounts established at the outset. This straight forward, three-step process is standard practice in the swap market and results in the effective transformation of a debt raised in one currency into a fully-hedged fixed-rate liability in another currency.
In principle, the fixed currency swap structure is similar to the conventional long–date forward foreign exchange contract. However, the counter-party nature of the swap market results in a far greater flexibility in respect of both maturity periods and size of the transactions which may be arranged. A currency swap structure also allows for interest rate differentials between the two currencies via periodic payments rather than the lump sum reflected by forward points used in the foreign exchange market. This enables the swap structure to be customized to fit the counter-parties exact requirements at attractive rates. For example, the cash flows of an underlying bond issue may be matched exactly and invariably.
Currency Coupon Swaps
The currency coupon swap is combination of the interest rate swap and the fixed-rate currency swap. The transaction follows the three basic steps described for the fixed–rate currency swap with the exception that fixed-rate interest in one currency is exchanged for floating rate interest in another currency. By using the currency coupon swap the benefit which can be obtained, can be explained with the following example. Suppose an Indian corporate wished to enter a major leasing contract for a capital project to be sited in Japan. The corporate wanted to obtain the advantage of funding through a Japan’s lease which provided lower lease rentals due to the Japan tax advantages available to the Japan lessor. However, the Corporate was concerned by both the currency and interest rate exposure which would result from the yen based leasing contract. The structure provided by Bankers Trust enabled the Corporate to obtain the cost benefits available from the Japan lease and at the same time convert the underlying lease finance into a fully–hedged fixed-rate yen liability. Under the structure Bankers Trust paid, on a quarterly basis, the exact payments due on the Corporate’s yen based Japan lease in return for the Corporate paying an annual amount of fixed Japanese Yen to Banker’s Trust. The amount for fixed Japanese Yen payable reflected the beneficial level of the Japanese Yen lease payments.
Credit: International Finance Notes-MGU