Currency swaps are an essential financial instrument utilized by banks, multinational corporations, and institutional investors. Although these type of swaps function in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that make currency swaps unique and thus slightly more complicated.

A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional exchange, periodic cash flows are exchanged in the appropriate currency.

First, let's take a step back to fully illustrate the purpose and function of a currency swap.

Purpose of Currency Swaps

An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from the unwillingness of Brazilian banks to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable interest rate in the U.S. market. The Brazilian Company may only be able to obtain credit at 9%.

While the cost of borrowing in the international market is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities.

Setting up the Currency Swap

Using the example above, based on the companies' competitive advantages of borrowing in their domestic markets, Company A will borrow the funds that Company B needs from an American bank while Company B borrows the funds that Company A will need through a Brazilian Bank. Both companies have effectively taken out a loan for the other company. The loans are then swapped. Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both companies require the same equivalent amount of funding, the Brazilian company receives $100 million from its American counterpart in exchange for 160 million Brazilian real, meaning that these notional amounts are swapped.

Company A now holds the funds it required in real, while Company B is in possession of USD. However, both companies have to pay interest on the loans to their respective domestic banks in the original borrowed currency. Although Company B swapped BRL for USD, it still must satisfy its obligation to the Brazilian bank in real. Company A faces a similar situation with its domestic bank. As a result, both companies will incur interest payments equivalent to the other party's cost of borrowing. This last point forms the basis of the advantages that a currency swap provides.

Either company could conceivably borrow in its domestic currency and enter the foreign exchange market, but there is no guarantee that it won't end up paying too much in interest because of exchange rate fluctuations.

Another way to think about it is that the two companies could also agree to a swap that establishes the following conditions:

First, Company A issues a bond payable at a certain interest rate. It can deliver the bonds to a swap bank, which then passes it on to Company B. Company B reciprocates by issuing an equivalent bond (at the given spot rates), delivers to the swap bank and ends up sending it to Company A.

These funds will likely be used to pay back domestic bondholders (or other creditors) for each company. Company B now has an American asset (the bonds) on which it must pay interest. Interest payments go to the swap bank, which passes it on to the American company and vice versa. At maturity, each company will pay the principal back to the swap bank and, in turn, receive its original principal. In this way, each company has successfully obtained the foreign funds that it wanted, but at lower interest rates and without facing as much exchange rate risk.

Advantages of the Currency Swap

Rather than borrowing real at 10%, Company A will have to satisfy the 5% interest rate payments incurred by Company B under its agreement with the Brazilian banks. Company A has effectively managed to replace a 10% loan with a 5% loan. Similarly, Company B no longer has to borrow funds from American institutions at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty. Under this scenario, Company B actually managed to reduce its cost of debt by more than half. Instead of borrowing from international banks, both companies borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap.

For simplicity, the aforementioned example excludes the role of a swap dealer, which serves as the intermediary for the currency swap transaction. With the presence of the dealer, the realized interest rate might be increased slightly as a form of commission to the intermediary. Typically, the spreads on currency swaps are fairly low and, depending on the notional principals and type of clients, may be in the vicinity of 10 basis points. Therefore, the actual borrowing rate for Companies A and B is 5.1% and 4.1%, respectively, which is still superior to the offered international rates.

Currency Swap Considerations

There are a few basic considerations that differentiate plain vanilla currency swaps from other types of swaps such as interest rate swaps and return based swaps. Currency-based instruments include an immediate and terminal exchange of notional principal. In the above example, the US$100 million and 160 million Brazilian real are exchanged when the contract is initiated. At termination, the notional principals are returned to the appropriate party. Company A would have to return the notional principal in real back to Company B, and vice versa. The terminal exchange, however, exposes both companies to foreign exchange risk, as the exchange rate may shift from its original 1.60BRL/1.00USD level.

Additionally, most swaps involve a net payment. In a total return swap, for example, the return on an index can be swapped for the return on a particular stock. On every settlement date, the return of one party is netted against the return of the other and only one payment is made. In contrast, because the periodic payments associated with currency swaps are not denominated in the same currency, payments are not netted. Therefore, in every settlement period both parties are obligated to make payments to the counterparty.

The Bottom Line

Currency swaps are over-the-counter derivatives that serve two main purposes. First, they can be used to minimize foreign borrowing costs. Second, they could be used as tools to hedge exposure to exchange rate risk. Corporations with international exposure utilize these instruments for the former purpose while institutional investors would typically implement currency swaps as part of a comprehensive hedging strategy.

It also may be more expensive to borrow in the U.S. than it is in another country, or vice versa. In either circumstance, the domestic company has a competitive advantage in taking out loans from its home country because its cost of capital is lower.