What are Currency Swaps?

A currency swap is an exchange that occurs between two individuals or entities holding set currencies for a specified period of time after which, they will be exchanged back.  This can occur between two or more parties.  Upon the maturity of the exchange, each party returns to the other the original amount of currency traded.  There is a wide degree of variance in the amount of time that can be set for maturity of the exchange, even going up to 30 years.  Due to laws of international accounting, currency swaps are not considered to be loans, and are thus not required to be documented on a company’s balance sheet.  Currency swaps can be helpful in terms of getting around foreign exchange controls without breaking the law. 

 

Instead of being considered a loan, currency swaps are treated as foreign exchange transactions with the maturity date closed as a forward contract, which is a simple agreement ensuring the date on which the amounts will be repaid.  The entirety of the cash flow contained within the swap is repaid upon maturity.  This includes the initial principal amount exchanged, the receipt or payment of interest in the same currency, and the eventual return of the amount exchanged when the deal matures.  

 

This type of arrangement tends to benefit companies who, for one reason or another need to acquire a specific currency, perhaps in order to satisfy a debt. There are numerous possible situations where such an exchange can be extremely beneficial to both parties involved in the swap.

 

The advantage of a currency swap situation is that it is incredibly flexible, allowing for large amounts of negotiable time.  The benefit of entering into a currency swap is that both companies involved can better manage or limit the risk of fluctuating interest rates or obtaining a lower interest rate.  Since the cash flow being generated is in a foreign currency, the companies involved have a reduced risk of being exposed to fluctuations in exchange rates.  Such arrangements also tend to reduce the risk of counterparty risk.  Also, though it may seem obvious, there is an interest rate swap occurring simultaneously with the currency swap.  There is also the possibility of drawing up contracts concerning fixed or floating rates.

 

It should be noted, however, that there are certainly possible disadvantages of currency swap arrangements.  There are risks involved in the swap itself, and companies should be aware of the costs involved.  One of the main risks is the possibility that the other company involved in the transaction will fail to meet the terms of the contract, either before or during the maturity of the contract.  Mutual consent must be sought if one entity has the desire to exit the contract early.  There are a few possible routes available if such a situation should occur.  The swap can be sold to a third party who will assume the terms of the contract.  There is also the possibility of an offsetting swap.