Fundamentals of Currency and Interest Rate Swaps

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.

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:

The following types of cross-currency swaps are generally used:

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

(iv) Neither

Benefits of Currency Swaps:

1. Currently swaps enable corporate to exploit their comparative advantage in raising funds in one currency to obtain savings in other currencies.
2. Currency swaps permit corporate to switch their loans from a particular currency to another depending on their expectations of the future movement of the currency and interest rates.
3. It offers flexibility to corporate seeking to hedge the risk associated with a particular currency.
4. A company no longer has to live with a bad decision, if it has selected a wrong currency for its overseas funding operations, a currency swap can undo the damage.
5. Currency swap can be used to lock into exchange rates for a longer period and it do not require monitoring and reviewing.
6. The currency swap mode can be chosen to restructure the currency base of companies liabilities.
7. Currency swaps are used to hedge exposure to currency risk on future receipts (asset swaps) and payments (liability swaps), and to raise funds at a lower cost.
8. A high degree of liquidity in currency swap market ensures a steady supply of principals ready to assume the opposite side of a transaction.
9. In a currency swap, the exchange rates at maturity is known at the outset.
10. Early termination of swap contracts may be possible by agreement of the counter parties.
11. Currency swaps can be entered into at any time during the life of the transaction, they are being used to hedge.

Interest Rate Swaps:

An interest rate swap is a simple agreement between two parties to exchange series of interest payments on an underlying loan.

There is no exchange of principal amount and an independent silent financial transaction takes place which does not affect the lender.

A fixed rate of interest is swapped for a floating rate of interest or vice versa.

An interest rate swap is a legal agreement between two parties to exchange their interest rate obligations or receipts.

Thus, in such a transaction, interest payment streams of differing characters are exchanged according to predetermined rules, and are based on an underlying notional principal amount.

Interest rate swaps can take different forms as they can be structured to meet each corporate’s specific requirements.

A ‘fixed-to-floating swap’ changes the profile of your foreign currency borrowings from fixed to floating rates, or vice versa. Ideally, to minimize the interest rate risk over the life-span of the loan, a corporate should move from a floating to a fixed rate term at the bottom of an interest rate cycle, and do the opposite at its crest.

A ‘coupon swap’, which is also known as an ‘interest-only swap’, is an agreement between two parties to exchange their interest rate obligations denominated in different currencies. For instance, if the interest rates on the US dollar are expected to rise, a company with dollar borrowings may wish to switch its interest payments to another currency whose interest rates are expected to be lower.

The interest swaps offers hedge against advance interest rate movements in future and also creation of new, low cost borrowing alternatives.

When a company borrow to advantage with one type of financing but really prefers another, its sources will engage in a swap with an interest rate swap, interest payment obligations are exchanged between two parties, but they are denominated in the same currency.

The most common swap is the floating/fixed rate exchange.

The popular form of interest rate swap is a ‘plain vanilla’ swap, in which fixed and floating interest payments are based on some notional principal amount.

Fixed Interest Rate vs. Floating Interest Rate

Interest rate swaps usually involve the exchange of one stream of future payments based on a fixed interest rate for a different set of future payments that are based on a floating interest rate. Thus, understanding the concepts of fixed-rate loans vs. floating rate loans is crucial to understanding interest rate swaps.

A fixed interest rate is an interest rate on a debt or other security that remains unchanged during the entire term of the contract, or until the maturity of the security. In contrast, floating interest rates fluctuate over time, with the changes in interest rate usually based on an underlying benchmark index. Floating interest rate bonds are frequently used in interest rate swaps, with the bond’s interest rate based on the London Interbank Offered Rate (LIBOR). Briefly, the LIBOR rate is an average interest rate that the leading banks participating in the London interbank market charge each other for short-term loans.

The LIBOR rate is a commonly used benchmark for determining other interest rates that lenders charge for various types of financing.

How Does an Interest Rate Swap Work?

Basically, interest rate swaps occur when two parties – one of which is receiving fixed-rate interest payments and the other of which is receiving floating-rate payments – mutually agree that they would prefer the other party’s loan arrangement over their own. The party being paid based on a floating rate decides that they would prefer to have a guaranteed fixed rate, while the party that is receiving fixed-rate payments believes that interest rates may rise, and to take advantage of that situation if it occurs – to earn higher interest payments – they would prefer to have a floating rate, one that will rise if and when there is a general uptrend in interest rates.

In an interest rate swap, the only things that actually get swapped are the interest payments. An interest rate swap, as previously noted, is a derivative contract. The parties do not take ownership of the other party’s debt. Instead, they merely make a contract to pay each other the difference in loan payments as specified in the contract. They do not exchange debt assets, nor pay the full amount of interest due on each interest payment date – only the difference due as a result of the swap contract.

A good interest rate swap contract clearly states the terms of the agreement, including the respective interest rates each party is to be paid by the other party, and the payment schedule (e.g., monthly, quarterly, or annually). In addition, the contract states both the start date and maturity date of the swap agreement, and that both parties are bound by the terms of the agreement until the maturity date.

Note that while both parties to an interest rate swap get what they want – one party gets the risk protection of a fixed rate, while the other gets the exposure to potential profit from a floating rate – ultimately, one party will reap a financial reward while the other sustains a financial loss. If interest rates rise during the term of the swap agreement, then the party receiving the floating rate will profit and the party receiving the fixed rate will incur a loss. Conversely, if interest rates decline, then the party getting paid the guaranteed fixed rate return will benefit, while the party receiving payments based on a floating rate will see the amount of the interest payments it receives go down.

Risks of Interest Rate Swaps

Interest rate swaps are an effective type of derivative that may be of benefit to both parties involved in using them, in a number of different ways. However, swap agreements also come with risks.

One notable risk is that of counterparty risk. Because the parties involved are typically large companies or financial institutions, counterparty risk is usually relatively low. But if it should happen that one of the two parties defaults and is unable to meet its obligations under the interest rate swap agreement, then it would be difficult for the other party to collect. It would have an enforceable contract, but following the legal process might well be a long and twisting road.

Just dealing with the unpredictable nature of floating interest rates also adds some inherent risk for both parties to the agreement.