A currency swap is a transaction where deal where two entities agree to exchange two fixed rate interest payments the principal of a debt instrument in two different currencies. A currency swap is an agreement between two entities (usually from different countries) to exchange the principal and interest on the loan principal at its current market rate on value. This is usually done for mutual benefits and to protect against the risk of sudden currency exchange rate fluctuations.
What necessitates a swap transaction in the forex market? The best way to illustrate this is to look at this scenario painted below.
The Situation
Jones is the owner of a business in Germany and he has 250,000 Euros cash domiciled in his company?s fixed deposit account with Commerzbank, earning short-term interest. A business opportunity comes up in the United States which requires him to invest US$240,000 and he decide to use money from the account in Commerzbank to finance the deal. How does Jones handle this deal without being caught out by any foreign exchange fluctuations given the situation in the Eurozone which has made the Euro extremely volatile against most global currencies?
Enter The Product: The Foreign Exchange Swap
For Jones to handle the deal above without incurring the risk of being caught out by a foreign exchange fluctuation, he has to undertake a forex swap transaction.
A forex swap is suitable for companies and business who do international business that require constant foreign exchange transactions, especially when assets are held in different currencies from the liabilities. Two swaps are done. First, the party performing the swap exchanges one currency for another at an agreed exchange rate, with an obligation to re-exchange the currencies at a future date and at an agreed exchange rate. All agreements are made at the commencement of the swap contract.
The Solution
Going back to the scenario painted above, Jones agrees to sell his Euros to a Bureau de Change (BDC) operator at a spot exchange rate of 1.2000. He needs US$240,000 for this deal, so he delivers 200,000 Euros to the BDC operator and gets $240,000. Jones also agrees to return the USD in two months at an exchange rate of 1.1950.
Why is the exchange rate now reduced to favour Jones, since the reduced exchange rate would mean he gets more Euros out of the USD? This is done to balance out the effects of the interest rate differentials between the US and the Eurozone. Typically, the exchange rate at the time the second swap is to occur is tilted in favour of the party who originally owns the higher interest currency.
In a forex swap, the entire amounts involved are returned in full.
Advantages
- A forex swap allows a company access to a cheaper and better way of getting foreigh exchange without being subjected to the risk of exchange rate fluctuations.
- Forex swaps can be used as a instrument for hedging. A company can decide to shift away from holding its cash in one currency to a more stable currency, especially when its analysis shows that there will be a progressive weakening of the parent currency. We are currently seeing this in Iran as business move away from holding their money in the fast depreciating Iranian Rial to the US Dollar as the effects of the economic sanctions bite the Iranian economy harder.
- A forex swap deal can bring together two companies with complementary interest in each other?s countries, providing opportunities for better business cooperation and opportunities.
Disadvantages of Currency Swaps
- There is much more credit risk with a forex swap.
- The risk of default in the second swap deal is also present and this could have negative repercussions on the other party.
Source: http://blog.forex4you.com/what-are-forex-swaps/
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