What are Foreign Currency Swaps?
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.