Currency Swap - Explained
What is a Currency Swap?
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Table of ContentsWhat is a Currency Swap?How Does a Currency Swap Work?Academic Research for Currency Swap
What is a Currency Swap?
In the world of finance, a currency swap can also be termed as a cross-currency swap. Its an interest rate derivative. A currency swap is known to have pricing associations with different interest rate swaps, foreign exchange, in addition to FX swaps.
How Does a Currency Swap Work?
As the name suggests, a currency swap refers to an adequate description that defines a derivative contract. Usually, the contents of the arrangement entail an agreement between two individuals where there's specification about the nature of the payment terms. This payment is generally denominated in two main currencies. The deal also gives a breakdown of the initial exchange about the notional currency in every different currency. The conditions of that repayment in regards to notional currency are also shared in the agreement. One of the most prominent currency swaps is traded in different interbank industries. Its a mark-to-market currency that entails national exchanges that are often made throughout the cycle of the swap in relation to the rate fluctuations. The whole process is based on wanting to uphold a swap whose market-to-market value maintains its neutral nature and does not become a large asset. With that said, a currency swap has numerous uses including securing cheaper debt where one can borrow at the best rate regardless of the currency. They can then swap for the debt they desire to have using a back-back-loan. Additionally, a currency swap is used as a hedge against forwarding exchange rate fluctuations. This implies that it helps to reduce risks in business. Lastly, a currency swap can be used to defend one against financial turmoil where it allows a country impacted by liquidity to borrow money from other countries with its currency. Being OTC elements, currency swaps can be tailored into various ways that can also be structured to meet the specifications of the requirements of the counterparties. For instance, payment dates may be irregular. Therefore, the notional of the swap can be amortized with time. Dates can be fixed, and mandatory break clauses can be inserted into the contract. A currency swap has the following defining features:
- A currency swap has no replication of funds
- A currency swap entails a relatively low-cost service particularly in the absence of a swap
- A currency swap holds onto the liquidity of the obligation
- It has an agreement form that obliges the payment of mutual interests
- Intermediaries facilitate the whole process
Aside from the mentioned characteristics of a currency swap, it's important to understand the critical structure of the exchange process.
- There must be the initial exchange of principals
- A currency swap must have interest payment made in specified counterparty apart from having the final transfer of principals and interchange.
Its vital to understand that currency swaps are an essential component in the modern financial market since they are the needed bridge for the assessment and evaluation of different standardized USD basis. As such, currency swaps are also utilized as a construction tool to help create collateralized discount curves in valuing an up and looking cash flow in a different currency but collateralized with another particular currency. Following the importance of security when it comes to the industry of financial system extensively, currency swaps are essential not only as instruments used in hedging funds but to insure assets against material collateral mismatches. With that said, here are the three types of a currency swap.
- Fixed-fixed currency swap - Fixed-fixed currency swap entails the exchange of loans in various currencies, where interest flows are calculated based on the fixed rate.
- A swap of floating-floating currencies - A swap of floating is a general currency swap in which the currents of interests corresponding to the respective currencies exchanged are calculated according to the type of variable.
- Fixed-floating currency swap - A fixed-floating swap refers to a contractual arrangement between two parties in which one of the parties swaps the interest cash flows of fixed-rate loans with those of the floating rate loans held by a different party. The principal of the underlying loan isn't exchanged.
Academic Research for Currency Swap
- The spillover of money market turbulence to FX swap and cross-currency swap markets, Baba, N., Packer, F., & Nagano, T. (2008). This paper seeks to analyze the spillover of the turmoil in money markets particularly in the second half of 2007 to FX swap as well as long-term cross-currency basis swap markets. Researchers conclude that the utilization of swap markets to overcome the US dollar funding shortages by foreign financial institutions resulted in marker deviations from various covered interest parity conditions as well as the impairment of liquidity in these markets.
- Cross currency swap valuation, Boenkost, W., & Schmidt, W. M. (2005). This article analyzes the fact that cross-currency swaps are often upheld as powerful instruments used to transfer assets or liabilities from one currency to the other. The market charges for the liquidity premium and the cross currency basis spread should be taken into account through the valuation methodology. As such, the research describes and compares two valuation methods for cross currency swaps which are based on using two different discounting curves. The first method is pretty popular in practice but very inconsistent with single currency swap valuation methods. On the same note, the second method is consistent for various swap valuations. However, it leads to make-to-market values for single currency off markets swaps.
- Long-term covered interest parity: evidence from currency swaps, Popper, H. (1993). Journal of International Money and Finance, 12(4), 439-448. This research paper establishes long-term arbitrage conditions by using a well-developed mechanism for hedging long-term currency positions. Using the arbitrage conditions, the bond yields denominated in various currencies are usually compared across the onshore markets of Canada, Switzerland, Japan, Germany, and the UK. The conclusion suggests that long-term financial capital is mobile across the stated markets. This is the case in the Euro market as well as across different political jurisdictions.
- Dynamic spillover of money market turmoil from fx swap to cross-currency swap markets: evidence from the 2007-2008 turmoil, Baba, N. (2009). The Journal of Fixed Income, 18(4), 24. This research paper tries to establish the results of the dynamic spillover of 2007 to 2008 money market turmoil from term FX swap to the cross-currency swap markets. In the ordeal, the short term covered parity deviation as well as long-term CIP deviation which is also known as cross-currency swap price is virtually in a significant cointegrating relationship. As such, the grander test indicates a substantial casualty from the short-term to the long-term deviation.
- Currency swaps and long-term covered interest parity, Takezawa, N. (1995). Economics Letters, 49(2), 181-185. This research paper employs daily updated data instead of weekly data applied in previous studies. The data was used to establish whether long-term covered interest parity applies when a currency swap is utilized as a hedging instrument. It was determined that large deviations weren't rare during the late 1980s. However, the same differences have been diminishing in recent years.
- Swap" covered interest parity in long-dated capital markets, Fletcher, D. J., & Taylor, L. W. (1996). The Review of Economics and Statistics, 530-538. This article addresses the benefits of using the currency swap as the main forward-exchange risk hedge. As such, the research covered interest parity condition in the long-date capital market. It was stated that deviations from parity could highly be attributed to various transaction costs. As such, the empirical results presented in the paper suggested that on average the transaction cost for deviations from parity and net differences are not rare or short-lived. An evaluation of the variance structure of covered interest parity levels reveals that the profit opportunities diminished over time. At some point, they disappear.
- OTC Derivatives Reforms and the Australian Cross-currency Swap Market, Arsov, I., Moran, G., Shanahan, B., & Stacey, K. (2013). RBA Bulletin, 55-64. This paper disintegrates the issue of using reforms to improve the management of counterparty credit risk through over-the-counter derivatives. The fundamental foundation of the improvements is the migration of these markets to central counterparties namely the CCPs, while the higher capital charges, as well as increased collateralization, will be applied to derivatives that have been withstanding non-centrally cleared. A class of over-the-counter derivates that will significantly be affected by the reforms is the cross-currency swaps. The stated elements are especially crucial to the financial system of Australia.
- A non-parametric analysis of covered interest parity in long-date capital markets, Fletcher, D. J., & Taylor, L. W. (1994). Journal of International Money and Finance, 13(4), 459-475. This article delves into the non-parametric analysis of covered interest parity in huge capital markets. It was established that the financially innovative currency swap had elevated the international mobility of long-term assets. The research team looked further into whether the covered interest parity condition holds in these markets with the currency swap as the forward exchange risk hedge. The conclusion presented in the research paper indicated that deviations from variously covered interest parity aren't rare.
- When and how US dollar shortages evolved into the full crisis? Evidence from the cross-currency swap market, Baba, N., & Sakurai, Y. (2011). Journal of Banking & Finance, 35(6), 1450-1463. This paper investigates when and how the American dollar shortages evolved into the crisis in the cross-currency swap market between European currencies as well as the 2007-2009 turmoil. It was discovered that the process occurred through the dynamic factor model with regime switching coefficients of every swap price concerning the common latent factor. As such, the 1-year market progressed into the big crisis regime after the outset of the central issue in August 2007.
- Swap rates and credit quality, Duffie, D., & Huang, M. (1996). The Journal of Finance, 51(3), 921-949. This paper presents a model used in valuing claims subjected to default by contracting various parties such as swaps alongside forwards. Coupled with counterparties of various default risks, its evident that the promised cash flows of a given swap are often discounted by switching a discount rate that is equal to the actual discount rate of the counterparty for whom the swap has run out of the money. With that said, the impact of credit-risk asymmetry as well as of netting is presented via theory as well as numerical examples including interest rates and currency swaps.
- Currency swaps as a long-term international financing technique, Park, Y. S. (1984). Journal of International Business Studies, 15(3), 47-54. This article offers a broad and well-researched framework that seeks to evaluate the currency swap transactions proposed by the World Bank in 1981. The assessment was based on the need to obtained long-term funds in slightly low-interest German marks as well as Swiss francs in exchange for high-interest dollar loans. The concept was pretty unique since it held a combination of conventional currency swap alongside a debt swap. The new technique provided different sets of financial incentives to the parties involved in the swap. While on one side participation may have minimized the effective borrowing cost while avoiding the high risk of potential market saturation, it was also established that the subject's counterpart could lock up the book value resulting from a favorable exchange rate.