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.
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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.