Presentation on

Currency Swap

Submitted To: Rutvi SarangSubmitted By: Yogita Chhabhaya

Currency swaps involve an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporate has a comparative advantage and to achieve a portfolio in a different currency of his choice, at a cost lower than if he accessed the market of the second currency directly. However, since these types of swaps involve an exchange of two currencies, an exchange rate, generally the prevailing spot rate is used to calculate the amount of cash flows, apart from interest rates relevant to these two currencies. By its special nature, these instruments are used for hedging risk arising out of interest rates and exchange rates.

DEFINITION:

A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agree at the start of the contract.

Generally two kinds of currency swaps have been used in the markets. These are fixed to fixed swaps and fixed (floating) to floating swaps which sometimes called as circus swaps or currency coupon swaps.Although the first step may be notional, typical currency swaps involves three steps:

Continue…………………1.Initial exchange of principal amount: In the first step, the

counterparties exchange the principal amounts of the swap at an agreed exchange rate. This rate is generally based on the spot exchange rate however, a forward rate set in advance of the swap commencement date may also be used. The principal amounts may be exchanged on physical or notional, without any physical change, basis.

2.Exchange of interest: It is the second key step for a currency swap. The counterparties exchange interest payments on agreed dates based on outstanding principal amounts at the fixed interest rates agreed at the beginning of transaction.

3.Re-exchange of principal maturity: This step involves re-exchange of the principal sum at the maturity date by the counterparts. In order to determine the actual sums involved generally the original spot rate is used.

Economic motives for swaps: Currency & interest rate swaps can the economically interpreted

in one three ways:(1) Risk sharing(2) Arbitrage(3) Market completions

(1) Risk Sharing :A company (or the other party ) has unmatched cash flows in terms of foreign currencies, or in terms of the proportion of variable rate , assets, matched by variable rate liabilities. the company finds the second party with a complementary mis match & arranges a swap in such a way that its foreign currencies cash flow are now more closely matched.

(2) Arbitrage:Swap may take place because arbitrage opportunity exit. these arbitrage opportunity arises from exchange or capital control, tax regulations or simple inconsistencies in market pricing of fixed rate versus floating rate debt (3) Market completion:Swaps could be turned “ market completion if they represent emergence of new markets for wish sharing giving rise to beneficial transaction that were not economically possible given the previously available market. Type of currency swaps:1) Long term forward contract:A long term forward contract is essentially a barter transaction. A company or institution seeks out a counter party with which it changes a contract to exchange two currencies at sometime in the future, the exchange to take place at price that is agreed today.

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2) Straight forward swap:A straight forward swap is the exchange of 2 currencies at the current exchange rate with an agreement to reverse the trade at the same exchange rate at same set rate in the future. One of the parties will pay the other annual interest payment. These interest payments are usually agreed to on the basis of the interest parity sudation. If interest rates on assets dominated in currency and are higher than in currency Bathe the party who receives currency A in exchange for currency B will pay the interest differential to the other party.

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3)Back to back & parallel loans:Back to back loans are loans between 2 companies in different countries, each of which makes the other a loan in its respective currency. Parallel loan involve two companies in different countries, each of which has a subsidiary in the other country. Each company makes a loan to the other company’s subsidiary..

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Comparative Advantage for Currency Swaps

Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries.

That is, suppose:Firm B can borrow in $ at 8.0%, or in € at 6.0%. Firm A can borrow in $ at 6.5% or in € at 5.2%.

If A wants to borrow €, and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market

in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.

TYPES OF CURRENCY SWAPS

1.) Cross-currency coupon swaps:

These are fixed-against-floating swaps.

2.) Cross-currency basis swap:

These swaps involve payments attached to a floating rate index for both thecurrencies. In other words, floating-against-floating cross-currency basis swaps.

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