Each entity has a different access and different needs in the international financial markets. Companies receive more favorable credit ratings in their country of domicile than in the country in which they need to raise capital. Investors are likely to demand a lower return from a domestic company, which they are more familiar with than from a foreign company. In some cases a company may be unable to raise capital in a certain currency. Currency swaps are also used to lower the risk of currency exposure or to change returns on investment into another, more favorable currency. Therefore, currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management.
A currency swap transaction involves an exchange of a major currency against the U.S. dollar. In order to swap two other non- U.S. currencies, a dealer may need to arrange two separate swaps. Although, any currency can be used in swaps, many counter-parties are unable to exchange their currencies due to a lack of demand. Since currency swaps involve die exchange of two or more types of currencies, the actual exchange of principals takes place at the commencement and the termination of the swaps. On certain occasions, the exchange occurs only at the inception of the swap depending on the nature of the swap. The exchange of principals is necessary because of the fluctuation of currencies. Also, counter parties may need to utilize the respective exchanged currencies. Principals and interest payments are exchanged based on the spot rate agreed at the inception of the swaps.
Although currency swaps are very useful in the situations described above, they should be used in every situation involving a foreign currency. For example, if the underlying currency of a foreign denominated debt is expected to depreciate, a smaller amount of domestic currency will be required to service the debt. Conversely, if the underlying currency of a foreign denominated asset is expected to appreciate, the domestic currency value of the asset will increase.
The uses of currency swaps are summarized below:
- Lowering funding cost: A company can raise capital in the most favorable market and exchange the currency for another by entering into a swap. Therefore, the fund-raiser is able to obtain a lower interest rate than if this party had tried to raise capital directly from foreign markets.
- Entering restricted capital markets: Each country has its own money and capital markets policy. Due to different tax schemes and credit standards in each country, one might not have the ability to raise capital in the currency one needs.
- Reducing currency risk: Whether making payments or receiving payments, most companies are involved in foreign currency transactions. By doing so, they are exposed to currency risks. Such risks can be minimized by exchanging foreign currency payments for home currency payments.
- Supply – demand imbalances in the markets: Temporary supply-demand imbalances in a market may lead to a change in interest rates. For example, if the Federal Reserve decides to lower capital requirements for banks, excess of funds will be released into the market. Excess supply of funds in a market will cause interest rates to fall and excess demand will trigger rise in interest rates. Through swaps, a borrower can raise funds from the market at more desirable rates.
The most common use of currency swaps is for institutions to fund their foreign exchange balances. Foreign currency swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
The following example demonstrates how currency risk can be hedged by entering into a foreign currency swap.
Based in Japan, Company X is a producer of semiconductors. Due to its innovative technology and global expansion strategy, X became one of the leading suppliers of memory chips. X bills its European customers in Euro and other customer in US dollar. Mr. A, the financial director of X is concerned with X’s exposure to Euro. Therefore, Mr. B of Y Bank arranged foreign currency swaps to assist Mr. A hedge X’s currency risks. Mr. B agrees to receive 6.5 % Euro payments for 6.5 % Yen payments plus an agreed front-end fee. The notional principal was set on Euro 10,000,000 to offset X’s annual revenue of Euro 2,800,000. As long as X’s sales in Europe do not drop drastically, X should be able to pay the annual interest payment of Euro 650,000 and accumulated enough Euro to make the final principal exchange. The exchange rate was set at 131 Yen/ Euro and the tenor of the swap is five years. By entering into this swap Mr. A can fix the exchange rate for the next five years.
The risks involved in foreign currency swaps are similar to those characteristic of the forward contract.
- Credit risk: If one of the counter-parties defaults on its obligations, the other party has to sign a new contract, thereby increasing its exposure to market interest rate fluctuations.
- Exchange rate risk: By fixing the exchange rates, at which the currency will be bought, the party forgoes the opportunity of profiting from a favorable exchange rate movement. Additionally, unfavorable exchange rate movements may take away further profit opportunity for the party (in the face of opportunity cost).
- Interest rate risk: Since the price of the forward contract is dependent on the differential between the interest rates that can be earned with two different currencies, variations in those interest rates can change the price of a forward contract, and thus also change the terms of a swap. The change can be favorable, as well as unfavorable to each party.
To conclude, foreign currency swaps are magical financial instruments which allow companies to exploit the global financial markets more efficiently. Foreign currency swap markets are an integral arbitrage link between the interest rates of different developed countries. Also, the future of banking lies in the securitization and diversification of loan portfolios. The global currency swap market will play an integral role in this transformation. Banks will come to resemble credit funds more than anything else, holding diversified portfolios of global credit and global credit equivalents with derivative overlays used to manage the variety of currency and interest rate risk.