Currency Swaps

A currency swap allows two parties to exchange equivalent amounts of different currencies initially, followed by exchanges in the series of interest payments that must be paid on each series. The swap is concluded at a future date when the initial trade in different currencies is reversed. A basic currency swap involves transactions in three separate cash flows. First, two parties exchange or swap equivalent amounts of two different currencies, perhaps yen for dollars. One party might be a U.S.- based corporation selling computers in Japan. The company generates revenue in yen, which it needs to convert into dollars to pay dividends to its stockholders. The other party could be a Japan-based corporation selling cameras in the United States.

This Japan-based company generates revenue in dollars, which it needs to convert into yen to pay dividends to its stockholders. In essence, these two companies initiate the swap by loaning each other equal sums of cash in their home currencies. The U.S.-based company loans dollars to the Japan-based company, and the Japan-based company loans an equivalent amount of yen to the U.S.-based company. Second, these two companies make interest payments to each other for the duration of the swap contract. The U.S.-based company receives interest payments in dollars from the Japan-based company earning dollar revenue in the United States. The Japan-based company receives interest payments in yen from the U.S.-based company earning yen revenue in Japan. Last, the two companies complete the swap by re-exchanging the exact sums of cash originally borrowed from each other. In the transaction, the two companies have protected themselves from adverse changes in exchange rates between the currencies of their home countries.

Currency swaps are a method of hedging foreign exchange risk over long spans of time. Foreign exchange risks have to do with risks associated with unanticipated changes in the rate at which a sum of money in one currency can be translated into a sum of money in another currency.

Currency swaps can be useful in a variety of situations. Take a U.S.-based company that plans to raise funds by selling bonds. Assume this company can issue bonds in Switzerland denominated in Swiss francs at a lower rate of interest than it can issue bonds in the United States. denominated in U.S. dollars. The risks of selling Swiss franc–denominated bonds arises from the possibility that the U.S. dollar might depreciate relative to the Swiss franc, leaving the U.S. company unable to generate enough dollars to pay off its Swiss bonds. To protect itself from exchange rate depreciation the U.S.-based company could enter into a currency swap agreement with a European bank. Suppose the U.S.-based company raised 100 million Swiss francs by selling Swiss franc–denominated bonds. In a currency swap agreement with a European bank, the U.S.-based company exchanges its 100 million Swiss francs into an equivalent amount of U.S. dollars. The European bank pays interest on the Swiss francs to the U.S.-based company. The U.S.-based company pays interest in dollars to the European bank. The U.S. bank will receive the Swiss franc interest payments on the same day that it owes interest payment on the Swiss franc bonds. When the Swiss franc bonds mature, the U.S.-based company will exchange dollars for Swiss francs with the European bank. The exchange rate for the final transaction would be part of the original swap agreement. The U.S.-based company will use the Swiss francs to redeem the bonds.

Central banks also engage in swap agreements with other central banks. During the subprime financial crisis of 2008, the Federal Reserve entered into a swap agreement with the European Central Bank. The European Central Bank needed dollars to meet the liquidity needs of some European banks that had liabilities denominated in dollars.