Currency swap: Contract that commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.

A currency swap has three stages:

An initial exchange of principal: the two counterparties exchange principal amounts at an agreed exchange rate. This can be a notional exchange since its purpose is to establish the principal amounts as a reference point for the calculation of interest payments and the re-exchange of the principal amounts.

Exchange of interest payments on agreed dates based on outstanding principal amounts and agreed fixed interest rates.

  1. Re-exchange of the principal amounts at a predetermined exchange rate so the parties end up with their original currencies.
  2. Again this may be done to hedge risk, to speculate on changes in exchange rates, or to attempt to lower the cost of borrowing by borrowing in the currency in which the most favourable interest rates are available and then swapping into the currency that the firm needs to carry out its business. Whether this will be cheaper will depend among other things on the bid—offer spread.

FundsA fixed rate currency swap is the exchange of a fixed interest rate loan in one currency for a fixed rate loan in another currency. This also may be beneficial to all parties because borrowers may have different credit ratings in different parts of the market. For example, a major international borrower, such as the World Bank, may wish to raise funds in Swiss francs but may have a particularly high credit rating in the US dollar market, allowing it to borrow in that market on very good terms. Thus, it may choose to borrow in dollars and swap with, say, a US company with a subsidiary in Switzerland.

A currency coupon swap is a combination of an interest rate swap and a fixed rate currency swap — both the interest rate structure and the currency are exchanged. Other types of swap include equity swaps, agreements to exchange the rate of return on an equity or an equity index for a floating or fixed rate of interest. Equity swaps can be used as an alternative to futures and options for hedging but are most attractive to fund managers trying to outperform an index. The fund manager receives a stream of payments replicating the return of a direct investment in an equity index and makes in return a stream of payments usually based on LIBOR. An equity swap may increase a fund manager’s ability to increase returns but because swaps, unlike futures, can run for up to ten years, the default risk is greater, although exposure to it is limited by payments normally being made every three months and because there is no exchange of principal.

In a commodity swap the counterparties exchange cash flows, at least one of which is based on a commodity price or commodity price index. A high proportion of the market is made up of oil-related transactions. A diff swap (or quanto swap) is the exchange of the cash flows on an asset or liability in one currency for those in another. A firm making a diff swap separates foreign exchange and interest rate exposure by paying interest rates based on one currency while taking the foreign exchange risk of another. The swap takes advantage of different-shaped yield curves to create immediate cost savings for the borrower and allows an investor to receive higher interest rates without changing currency exposure. Such an agreement typically runs from three to five years and so the risk for either borrower or investor is that the shape of one or both yield curves will change more quickly than expected, turning expected benefits into losses. Diff swaps became common when US and European interest rates diverged sharply. They involve correlation risk — an assumption that there will be a correlation between an interest rate movement and that of the currency. With a LIBOR-in-arrears swap, the borrower essentially takes a bet that implied forward rates are wrong by having LIBOR set, say, six months in arrears.

It is also possible to combine a zero coupon bond with an interest rate swap (known as a zero coupon swap). Then there are swaptions — options that give the right to enter into a swap within a specified period. Because swaps are off-balance-sheet business but carry risks for the swap bank, there was a concern in the past that banks might take on more risk through swaps than was justified by the size of their capital backing. Because currency swaps involve both default risk and exchange rate risk, they require higher capital backing under the Basel rules and this has slowed down their expansion relative to interest rate swaps.

There are yet other derivatives which do not fit neatly under the futures, options and swaps headings. One such are equity protected notes — zero-coupon, index-linked notes that allow investors to protect themselves against potential losses without giving up the possibility of gains. Dynamic hedging involves the buying and selling of forward contracts in the market in order to replicate options. It became popular in foreign exchange markets after the problems in the European Monetary System in 1992, which caused options prices to rise sharply. Safes (synthetic agreements for forward foreign exchange) are forward contracts that do not require an exchange of principal. This means that banks need to devote less capital to them and are less exposed to default risk. There are two types of safe: the Exchange Rate Agreement (ERA) which protects the purchaser against a change in the forward foreign exchange spread, and the Forward Exchange Agreement (FXA) which gives protection against a change in the spot rate as well as the forward spread. Insurance risk contracts are futures and options on catastrophe insurance, health, and home-owner’s and reinsurance risk.

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