Swap contracts can be arranged across currencies. Such contracts are known as currency swaps and can help manage both interest rate and exchange rate risk. Many financial institutions count the arranging of swaps, both domestic and foreign currency, as an important line of business. This method is virtually cheaper than covering by way of forward options. Technically, a currency swap is an exchange of debt service obligations denominated in one currency for the service in an agreed upon principal amount of debt denominated in another currency. By swapping their future cash flow obligations, the counterparties are able to replace cash flows denominated in one currency with cash flows in a more desired currency.
A ‘swap deal’ is a transaction in which the bank buys and sells the specified foreign currency simultaneously for different maturities. Thus a swap deal may involve:
- simultaneous purchase of spot and sale of forward or vice verse ; or
- Simultaneous purchase and sale, both forward but for different maturities. For instance, the bank may buy one month forward and sell two months forward. Such a deal is known as ‘forward swap’.
A swap deal should fulfil the following conditions:
There should be simultaneous buying and selling of the same foreign currency of same value for different maturities; and
(i) The deal should have been concluded with the distinct understanding between the banks that it is a swap deal.
A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deals the following factors enter into the rates:
(i) The difference between the buying and selling rates ; and
(ii) The forward margin, i.e., the premium or discount.
In a swap deal the first factor is ignored and both buying and selling are done at the same rate. Only the forward margin enters into the deal as the swap difference.
In a swap deal, both purchase and sale are done with the same bank and they constitute two legs of the same contract. In a swap deal, it does not really matter as to what is spot rate. What is important is the swap difference which determines the quantum of net receipt of payment for the bank as a result of the combined deal. But the spot rate decides the total value in rupees that either of the banks has to deploy till receipt of forward proceeds on the due date. Therefore, it is expected that the spot rate is the spot rate ruling in the market. Normally, the buying or selling rate is taken depending upon whether the spot side is respectively a sale or purchase to the market-maker. The practice is also to take the average of the buying and selling rates. However, it is of little consequence whether the purchase or selling or middle rate is taken as the spot rate
Need for Swap Deals:
Some of the cases where swap deal may become necessary are described below:
- When the bank enters into a forward deal for a large amount with the customer and cannot find a suitable forward cover deal in the market, recourse to swap deal may become necessary.
- Swap may be needed when early delivery or extension of forward contracts is effected at the request of the customers. Please see chapter on Execution of Forward Contracts and Extension of Forward Contract.
- Swap may be carried out to adjust cash position in a currency. This explained later in the chapter on Exchange Dealings.
- Swap may also be carried out when the bank is overbought for certain maturities and oversold for certain other maturities in a currency.
NB: Swap and Deposit/Investment: Let us suppose that the bank sells USD 10,000 three months forward, Instead of covering its position by a forward purchase, the bank may buy from the market spot dollar and kept the amount in deposit with a bank in New York. The deposit will be for a period of three months. On maturity, the deposit will be utilized to meet its forward sale commitment. Such a transaction is known as ‘swap and deposit’. The bank may resort to this method if the interest rate at New York is sufficiently higher than that prevailing in the local market. If instead of keeping the amount in deposit with a New York bank, in the above case, the spot dollar
purchased is invested in some other securities the transaction is known as ‘swap and investment’.