Currency swaps are foreign exchange contracts in which two parties agree to exchange the principal and interest of a loan in one currency with the principal and interest of an equivalent loan in another currency.
The motive behind a currency swap is to enable each party to gain exposure to another currency at a more competitive rate. A currency swap deal will be driven by comparative advantage.
For example, assume that a US Company wants to do some business in India, and at the same time an Indian company is looking at taking a loan in the US. Both the businesses could find it difficult to get competitive financing. The Indian banks may offer a loan to a US company at 11%, while they may be willing to offer the same loan to an Indian company at a lower rate, say 7%. Similarly, it will be cheaper for a US Company to take a loan in the US compared to the Indian Company.
In the international market, the financing is expensive for both these companies; however, they have a cost advantage in their domestic markets. The following table presents a hypothetical scenario:
US Company
Indian Company
Finance cost in US
6%
10%
Finance Cost in India
11%
7%
There is a clear comparative advantage if these two companies borrow in their home countries and exchange the cash flows.
Assume that both the companies have an equivalent loan requirement of $10million, and the current exchange rate is USD/INR 45.
The US Company will borrow $10million from a US bank at 6%. The Indian Company will borrow INR450mn from an Indian bank at 7%.
The swap transaction will take place as follows:
After borrowing from their local banks, both the companies will exchange the principals at the beginning of the arrangement.
As per the prescribed payment schedule (quarterly, semi-annually, or yearly), both the companies will exchange the interest payment on their loans.
At the end of the swap agreement, the companies will re-exchange the principals.
Note that this example assumes a simplified scenario. In a real transaction, there will be a swap dealer who facilitates this swap deal. To pay commissions to the dealer, the interest rates will become slightly higher. If the spread is assumed to be 20bps, the actual interest rate will be 6.2% and 7.2%.
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