Currency swaps are designed for when a company exchanges fixed-rate borrowing for variable rate borrowing.
When two parties exchange the principal amount of a loan while the interest rate swap is in one currency and the principal does not change hands, it is an agreement known to be a currency swap.
In obtaining foreign currency loans at a healthier interest rate than a company could attain by borrowing directly in a foreign market, currency swaps are used.
The purpose is to hedge exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.
Also, the currency swaps are identified as a cross-currency swap. It’s because two parties exchange principal and interest in different currencies with an off-balance sheet transaction.
A Two-way Exchange
As a counterparty, each side in the exchange is known.
The first party borrows a detailed amount of foreign currency from the counterparty at the foreign exchange rate in effect, considering a typical currency swap transaction. It also lends a corresponding amount to the counterparty in the currency that it holds at the same time.
Each participant pays interest to the other in the currency of the principal that it received during the duration of the contract. Meanwhile, both parties make repayment of the principal to one another when it reaches the expiration of the contract at a later date.
It has a Comparative Advantage
Benefits are given to participants such as obtaining financing at a lower interest rate than available in the local market and locking in a predetermined exchange rate for servicing a debt obligation in a foreign currency, while operations are being done.
Parties’ Contract before Exchanging Currency Swaps
Representing an agreement between two parties exchanges a series of cash flows over a specific period of the timer, swaps are used as derivative instruments.
There are multiple reasons why parties agree to such an exchange:
Changes in investment objectives or repayment scenarios may always occur.
In switching to newly available or alternative cash flow streams, there are possibilities of financial benefit.
With a floating rate loan repayment, minimizing and controlling is needed on the risk associated.
Types of Currency Swaps Contract
Fixed vs. Float: In this form, one leg of currency swap represents a stream of fixed-rate interest payments in one currency and are swapped for floating rate obligations in another currency.
Float vs. Float (basis swap): The float vs. float swap is commonly referred to as basis swap. In a basis swap, both swaps’ legs represent floating interest payments.
Fixed vs. Fixed: In this form, it may involve exchanging fixed interest payments on a loan in one currency for fixed interest payments on an equivalent loan in another currency.