AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2b. Currency Swaps 9 / 13

Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

iv) Currency swaps

Currency Swaps

What are they?

  • The exchange of debt from one currency to another

  • 2 companies agree to exchange payments on different terms (eg different currency)

Advantages

  1. Easy

  2. Low transaction costs

  3. Spread debt across different currencies

How to use them

Currency swaps are better for managing risk over a longer term (than currency futures or currency options)

A currency swap is an interest rate swap (between 2 companies) where the loans are in different currencies.

It begins with an exchange of principal, although this may be a notional exchange rather than a physical exchange.

During the life of the swap agreement, the companies pay each others’ foreign currency interest payments. At the end of the swap, the initial exchange of principal is reversed.

Example

Consider a US company X with a subsidiary Y in France which owns vineyards. Assume a spot rate of $1 = €0.7062. Suppose the parent company X wishes to raise a loan of €1.6 million for the purpose of buying another French wine company. 

At the same time, the French subsidiary Y wishes to raise $1 million to pay for new up-to-date capital equipment imported from the US. 

The US parent company X could borrow the $1 million and the French subsidiary Y could borrow the € 1.6 million, each effectively borrowing on the other's behalf. They would then swap currencies.