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Currency Swaps

Currency Swaps Assignment / Homework Help

Swaps are the exchange or swap of debt obligations, which may be interest and/or principal payments, between two parties. Currency swaps are generally arranged between two parties or companies through a bank. Swaps are beneficial to the parties dealing with it because they comfort the parties in terms of the desired currencies and provides convenience in making their specified principal and/or interest payments. Swaps are not financing instruments. The two types of swaps are interest swaps and currency swaps.

Interest Swap:

The transaction that involves exchange of interest obligations between two parties/firms is called as an interest swap.

Currency Swap:

The transaction that involves exchange of debt obligation which is denominated in different currencies is called as a currency swap.

Let us assume that Company A, a US firm, had issued USD25 million dollar – denominated bonds in the United States for financing an investment in Canada. Also, let us assume that at the same time, Company C, a Canada based firm, had issued USD 25 million dollars worth of Canadian dollar denominated bonds in Canada to fund an investment in the United States. Company C earns in U.S dollars but is required to execute payments in Canadian Dollars. Similarly, Company A earns in Canadian dollars but is required to execute payments in U.S. Dollars. Both the companies A & C, now, are subject to and exposed to foreign exchange risk, as a result of their aforesaid functional nature. If both the companies swap the payment obligations, foreign exchange risk exposure will be eliminated for both. Sometimes, extra payment may be involved between companies, which depend upon the specific company’s creditworthiness. But the risk of non-payment of debt obligation lies with the company that had issued the bonds initially. Apart from this, interest rate differences may also exist with respect to the issued bonds, which may require adjustment or compensation from one firm to another firm. Practically, currency swaps may also include interest rate swaps. There are three aspects involved in currency swaps. They are:
  • Companies/parties involving in exchange of debt obligations, in different currencies
  • Each of the company/party agrees to pay or settle the obligation of interest of the other company/party
  • Principal amounts, upon maturity are exchanged at an advanced agreed exchange rate

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