Currency SWAPs

Currency SWAPs are a tool for hedging foreign exchange risk.

A currency swap allows the two counterparties to swap interest rate commitments on borrowings in different currencies.

In effect a currency swap has two elements:

• An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.
• An exchange of interest rates - the timing of these depends on the individual contract.

The swap of interest rates could be "fixed for fixed" or "fixed for variable".

Illustration

Warne Co is an Australian firm looking to expand in Germany and is thus looking to raise €24 million. It can borrow at the following fixed rates:

A$ 7.0%

€ 5.6%

Euroports Inc is a French company looking to acquire an Australian firm and is looking to borrow A$40 million. It can borrow at the following rates:

A$ 7.2%

€ 5.5%

The current spot rate is A$1 = €0.6.

Show how a "fixed for fixed" currency swap would work in the circumstances described, assuming the swap is only for one year and that interest is paid at the end of the year concerned.

Solution

Net result:

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Tags:	currency swaps;foreign exchange risk;swaps