Foreign Currency Risk Management: Deep Dive in Currency Swap
From past ACCA Advanced Financial Management exam, foreign exchange risk management is another very important topics that you cannot pass without deeply understand how to apply the tools. We start describing it and then go into the details of currency swaps.
Currency Risk can be defined as a financial risk that arises from potential changes in the exchange rate of one currency with respect to the other currency. All companies that conduct businesses with companies located at a different geographical location are impacted by this risk.
There are a number of methods that can be employed by companies in order to hedge the existing exchange rate risk. Currency Swaps are one of the most popular ways using which foreign exchange rate risk can be managed by companies.
Currency Swaps can simply be defined as a way that enables companies to hedge against currency risk by swapping cash flows in the foreign currency with domestic pre-determined rates by the company in perspective. At the inception of the Currency Swap, principal amounts are exchanged at the respective spot rates. During the course of the transaction, the respective principal amounts are exchanged at the given spot rate.
What is meant by Currency Swaps?
A Currency Swap constitutes of interest, and principal, in one currency for the same another currency. It is mainly used by companies that have foreign business dealings, in order to get more favorable loans in their local currency as compared to the amount they would have paid in case they had borrowed money from their local bank.
Regardless of the fact that they are considered as a foreign exchange transaction, these swaps are not supposed to be necessarily shown on company’s balance sheet.
What are the differences between Currency Swaps and FX (or FOREX) swaps?
Currency Swaps are often confused with FX or Forex Swaps. However, it must be ensured that there is a clear distinction between FX Swaps and Currency Swaps. Firstly, FX Swaps are mostly contracted on a short term basis. They are employed for a time period of less than (or equal to) 12 months. They are mostly used to rollover forward contracts, in addition to modify existing contract sizes.
On the other hand, currency swaps are used for a relatively longer time period, which can be defined as medium to long term. This can range from 2 to 15 years. They are normally considered as effective tools that can be used to minimize the borrowing costs associated with businesses and their respective foreign dealings.
More importantly, a currency swap is often referred to as a cross currency swap, and for all practical purposes the two are basically the same. But there can be slight differences. Technically, a cross currency swap is the same as an FX swap, except the two parties also exchange interest payments on the loans during the life of the swap, as well as the PRINCIPAL amounts at the beginning and end.
Why do companies need to hedge with currency swaps?
Currency Swaps are considered as an effective tool for businesses to hedge their respective risks. Currency swaps are considered to be an effective tool to hedge against possible risks associated with exchange rate fluctuations.
During a normal course of the business, they are always exposed to fluctuating exchange rate risks, which might considerably skew their costing, and financials over the course of time. Therefore, they use Currency Swaps to ensure that they are able to hedge against this possible risk, in order for them to be able to reduce the impact of this fluctuation.
In addition to a mitigating the inherent risk involved with exchange rate volatility, Currency Swaps are also considered to be increasingly effective in ensuring receipt of foreign transactions. It also provides a window of opportunity for the company to achieve better lending rates.
How do Currency Swaps work?
A Currency Swap can be defined as a financial instrument that involves exchange of interest in one respective currency with respect to the other currency in this context.
The process of Currency Swaps mainly lies on two notional principals that are mainly exchanged at the beginning and the end of the agreement. These principals are predetermined currency amounts, based on which the exchanged interest payments are subsequently agreed upon.
In Currency Swaps, two parties who conduct business exchange equivalent amounts of the respective currency they decide upon, and subsequently trade it back later on at a specified date. In certain cases it can also be seen that Currency Swaps are considered for offsetting loans, and the two sides pay each other interest based on the amounts they have exchanged. It can be seen that currency swaps are mainly carried out by financial institutions, which trade on their own behalf, of a non-financial corporation.
Example of Currency Swaps.
There can be a number of variations of Currency Swaps that can be applied to a proper analysis. All Currency Swaps also include transaction costs, which are unavoidable.
Party A pays a fixed rate on one currency, and the other party (i.e. Party B) pays a fixed rate on another currency
Party A (based in US) enters into an agreement with a European Company (Party B). Party A, in this scenario, will borrow an amount in the US (at a comparatively lower rate), and then convert the amount to European Currency.
On the other hand, Party B will enter a contract with their domestic bank too, and then convert the amount to USD. Once converted, the rate would be fixed as per that date.
After entering currency swap, Party A is paying interest to a local US bank and receiving US$ interest in the currency swap agreement but paying EU€ interest. At the end of currency swap agreement, Party A receives the agreed amount of US$ by paying the agreed amount of EU€ (the principal).
Therefore, it can be seen that Currency Risk is something that equally impacts companies, as well as the parties they are into business with. Given the existing volatility in the exchange rate market, it can be seen that it is imperative for companies to manage this risk in order to keep their financial transactions hedged against the possible risk.
Companies can therefore significantly improve their risk-return profile using Currency Swaps. It can help them predict the outcome of financial transactions with relative surety, because they would have already entered into contracts well beforehand.
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