A currency swap is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loan in another currency. These contracts are valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest payments for floating-rate payments on dates specified by the two parties.
Since the exchange of payment takes place in two different currencies, the prevailing spot rate is used to calculate the payment amount. This financial instrument is used to hedge interest rate risks.
How Does a Currency Swap Work?
A currency swap agreement specifies the principal amount to be swapped, a common maturity period and the interest and exchange rates determined at the commencement of the contract. The two parties would continue to exchange the interest payment at the predetermined rate until the maturity period is reached. On the date of maturity, the two parties swap the principal amount specified in the contract.
The equivalent amount of the loan value in another currency is calculated by using the net present value (NPV). This implies that the exchange of the principal amount is carried out at market rates during the inception and maturity periods of the agreement.
Benefits of Currency Swaps
The benefits of currency swaps are:
- Help portfolio managers regulate their exposure to interest rates.
- Speculators can benefit from a favorable change in interest rates.
- Reduce uncertainty associated with future cash flows as it enables companies to modify their debt conditions.
- Reduce costs and risks associated with currency exchange.
- Companies having fixed rate liabilities can capitalize on floating-rate swaps and vise versa, based on the prevailing economic scenario.
Limitations of Currency Swaps
The drawbacks of currency swaps are:
- Exposed to credit risk as either one or both the parties could default on interest and principal payments.
- Vulnerable to the central government’s intervention in the exchange markets. This happens when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a huge downturn in the value of the domestic currency.
Find out more about Cross Currency Swaps.