Currency Swaps in Simple Terms

What Are Currency Swaps?

Currency swaps are essential derivative instruments for companies and investors operating in international markets. They allow the conversion of payment flows from one currency to another while benefiting from preferential interest rates.

Why Use a Currency Swap?

When a company borrows in a foreign currency, it is often exposed to exchange rate fluctuations and potentially higher interest rates compared to borrowing in its local currency.

A currency swap can help optimize costs by leveraging comparative advantages in different interest rate environments.

Example: Interest Rate Arbitrage

Take two companies, A (AAA-rated) and B (BBB-rated), both needing to borrow €10M for five years.

• A prefers a floating-rate loan but can borrow at 4% fixed or EURIBOR + 30 bps.
• B prefers a fixed-rate loan but faces 5.2% fixed or EURIBOR + 100 bps.

The fixed-rate spread is 1.2% (5.2% - 4.0%), while the floating-rate spread is only 0.7% (EURIBOR + 100 - EURIBOR + 30).

This means B has a relative advantage in floating-rate borrowing, while A benefits more in the fixed-rate market, creating an opportunity for a swap to lower costs for both.

Example: A European Company Seeking to Borrow in USD

A direct loan in USD would cost the company 6% annual interest. However, it can borrow in EUR at a rate of 3%.

Using a EUR/USD currency swap, it can convert its EUR-denominated loan into a USD liability, benefiting from the lower EUR interest rate and securing a fixed exchange rate for future USD payments.

How a Currency Swap Works: Cash Flows

A currency swap is a contract in which two parties exchange interest payments and/or principal amounts in different currencies.

Key Features:

• Exchange of notional amounts: At the beginning of the swap, the parties exchange a principal amount in their respective currencies. At maturity, they return these notional amounts.
• Exchange of interest payments: Each party pays an interest rate in the currency they borrow and receives an interest rate in the other currency.
• Fixed or floating interest rates: Swaps can be fixed-to-fixed or fixed-to-floating.

Step-by-Step Example of a Currency Swap

Suppose a European company needs $100 million for a project. Instead of borrowing directly in USD, it opts for a currency swap.

1. The company borrows €90 million (equivalent to $100 million at an exchange rate of 1 EUR = 1.11 USD).
2. It immediately exchanges the euros for dollars through a currency swap.
3. The company pays interest in USD at an agreed rate while receiving interest payments in EUR.
4. At maturity, the two parties re-exchange the notional amounts, and the company recovers its euros to repay the original loan.

This strategy enables the company to benefit from a lower EUR interest rate while securing its USD payment obligations at a known exchange rate.

Illustration of a Currency Swap

The diagram above shows the flow of funds in a typical currency swap.