Currency Swap

A currency swap is a derivative contract in which two parties exchange principal and interest payments denominated in different currencies. Currency swaps are used to obtain funding in a foreign currency, to hedge exposure to exchange rates, and to manage the composition of debt.

Structure

In a currency swap, the parties exchange principal amounts in different currencies at the outset and agree to exchange interest payments periodically. At maturity, the principal amounts are exchanged back at a predetermined rate, which may be the original rate or a different rate.

Interest payments may be fixed or floating. In a fixed-for-fixed swap, each party pays a fixed rate in its currency. In a fixed-for-floating swap, one party pays a fixed rate and the other pays a floating rate linked to a reference such as an interbank rate. The payments are typically made on the same dates and are sometimes netted.

Uses

Currency swaps are used to obtain foreign currency funding at a lower cost than would be available by borrowing directly in the foreign market. A firm that has a comparative advantage in borrowing in its domestic currency can borrow there and swap the proceeds into the currency it needs.

Currency swaps are used to hedge exposure to exchange rates. A firm with assets or liabilities in a foreign currency can use a swap to match the currency of its cash flows. They are used to manage the currency composition of debt, allowing issuers to adjust their exposure without redeeming and reissuing securities.

Currency swaps are also used by central banks, which establish swap lines to provide liquidity in foreign currencies to their domestic banking systems during periods of stress.

Pricing and Risk

The pricing of a currency swap reflects the interest rates in the two currencies, the expected path of the exchange rate, and the credit risk of the parties. The difference between the interest rates in the two currencies is reflected in the terms of the swap.

The main risks in a currency swap are exchange rate risk and credit risk. Exchange rate risk arises because the value of the payments depends on the exchange rate. Credit risk arises because a party may fail to make its payments, leaving the other party exposed. The use of collateral and of netting arrangements mitigates credit risk.

Market

The currency swap market is part of the over-the-counter derivatives market, in which contracts are negotiated privately rather than traded on exchanges. The market is dominated by large banks and other financial institutions, which act as dealers and as counterparties.

The market has grown substantially, reflecting the internationalisation of finance and the demand for currency risk management. Post-crisis reforms have increased the use of central clearing and of collateral in the derivatives market, affecting the structure and the cost of currency swaps.

Historical Development

Currency swaps emerged as a financial instrument in the late 1970s and early 1980s, in the context of the liberalisation of capital flows and of the growth of international finance. The first widely publicised currency swap was arranged between the World Bank and IBM in 1981, and it demonstrated the potential of the instrument to reduce funding costs.

The market grew rapidly in the 1980s and 1990s, as firms and financial institutions sought to manage their currency exposure and to obtain funding in foreign currencies. The development of standardised documentation, including the master agreements of the International Swaps and Derivatives Association, facilitated the growth of the market.

The market has continued to evolve, with the introduction of central clearing and of collateral requirements after the financial crisis. These changes have affected the cost and the structure of currency swaps, and they have increased the demand for high-quality collateral.

Central Bank Swap Lines

Central banks use currency swaps to provide liquidity in foreign currencies to their domestic financial institutions. A swap line between two central banks allows one to obtain the currency of the other and to lend it to institutions in its jurisdiction.

Swap lines are used during periods of stress, when the demand for foreign currency funding exceeds the supply available through private markets. The provision of swap lines can alleviate pressures in funding markets and can support the stability of the financial system.

The network of swap lines expanded significantly after the financial crisis, with major central banks establishing standing arrangements with one another. The design of these arrangements, including the conditions under which they are activated and the currencies covered, is a subject of ongoing debate.

Valuation and Accounting

The valuation of currency swaps requires the projection of future interest and principal payments in both currencies and the discounting of these payments at the appropriate rates. The valuation therefore depends on the interest rate curves in both currencies and on the exchange rate.

The accounting treatment of currency swaps depends on whether they are used for hedging or for trading, and on the accounting standards that apply. Swaps used to hedge exposure may qualify for hedge accounting, which allows the gains and losses on the swap to be recognised in the same period as the gains and losses on the hedged item.

The disclosure of derivative positions, including currency swaps, is required by accounting standards and by prudential regulation. The disclosure provides information about the scale and the nature of the risks that institutions run, and it is used by supervisors and by investors in assessing the soundness of institutions.

Summary

Currency swaps are a versatile instrument of international finance, used to obtain foreign currency funding, to hedge exchange rate exposure, and to provide liquidity across currencies. Their analysis requires attention to pricing, to risk, and to the institutional framework of the derivatives market.

See also

• Forward Premium
• Foreign Exchange Market
• International Economics