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Trading and Capital-Markets Activities Manual

Instrument Profiles: Currency Swaps
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)


A currency swap is a private over-the-counter (OTC) contract which commits two counterparties to exchange, over an agreed period, two streams of interest payments denominated in different currencies, and, at the end of the period, to exchange the corresponding principal amounts at an exchange rate agreed upon at the start of the contract. The term ''currency swap'' can sometimes be used to refer to foreign exchange swaps. Foreign-exchange swaps refers to the practice of buying or selling foreign currency in the spot market and simultaneously locking in a forward rate to reverse that transaction in the future. Foreign-exchange swaps, unlike currency swaps, do not involve interest payments-only principal amounts at the start and maturity of the swap. 


The term ''currency swap'' is used to describe interest-rate swaps involving two currencies. The strict application of the term is limited to fixed-against-fixed interest-rate swaps between currencies. Cross-currency swaps, a generic variation of the currency swap, involve an exchange of interest streams in different currencies, at least one of which is at a floating rate of interest. Those swaps that exchange a fixed rate against a floating rate are generally referred to as cross-currency coupon swaps, while those that exchange floating-against-floating using different reference rates are known as cross-currency basis swaps. 

Other types of cross-currency swaps include annuity swaps, zero-coupon swaps, and amortizing swaps. In cross-currency annuity swaps, level cash-flow streams in different currencies are exchanged with no exchange of principal at maturity. Annuity swaps are priced such that the level payment cash-flow streams in each currency have the same net present value at the inception of the transaction. Annuity swaps are often used to hedge the foreign-exchange exposure resulting from a known stream of cash flows in a foreign currency. For example, a U.S. corporation which receives a deutschemark (DM) 2 million semi-annual dividend payment from its German subsidiary can execute an annuity swap with a dealer in which it will make semi-annual payments of DM 2 million and receive semi-annual payments of $300,000-thus locking in a dollar value of its DM-denominated dividend payments. 

A zero-coupon swap involves no periodic payments (representing ''coupon'' payments). Rather, these cash flows are incorporated into the final exchange of principal. Cross-currency zero-coupon swaps are equivalent to a long dated forward contract and are used to hedge long-dated currency exposures when the exchange-traded and OTC foreign-exchange market may not be liquid. 

An amortizing cross-currency swap is structured with a declining principal schedule, usually designed to match that of an amortizing asset or liability. Amortizing cross-currency swaps are typically used to hedge a cross-border project-financing loan in which the debt is paid down over a series of years as the project begins to generate cash flow. Plain Vanilla Example Figure 1 illustrates the most simple example of a currency swap. An institution enters into a currency swap with a counterparty to exchange U.S. dollar interest payments and principal for offsetting cash flows in German DM.

Figure 1-Plain Vanilla Currency Swap

As illustrated, there are three stages to a currency swap. The first stage is an initial exchange of principal at an agreed rate of exchange, usually based on the spot exchange rate. The initial exchange may be on either a notional basis (no physical exchange of principal) or a physical exchange basis. The initial exchange is important primarily to establish the quantity of the respective principal amounts for the purpose of calculating the ongoing payments of interest and for the re-exchange of principal amounts under the swap. Most commonly, the initial exchange of principal is on a notional basis. 

The second stage involves the exchange of interest. The counterparties exchange interest payments based on the outstanding principal amounts at the respective fixed interest rates agreed on at the outset of the transaction. The third stage entails the re-exchange of principal. On maturity, the counterparties re-exchange principal at the original exchange rate agreed on at the execution of the swap. 


Currency swaps create exposures to the risk of changes in exchange rates and interest rates. Therefore, they can be used to take risk positions based on expectations about the direction in which the exchange rate, interest rates, or both will move in the future. Firms can alter the exposures of their existing assets or liabilities to changes in exchange rates by swapping them into foreign currency. Also, a reduction in borrowing costs can be achieved by obtaining more favorable financing in a foreign currency and using currency swaps to hedge the associated exchange-rate risks. Conversely, a firm can enhance the return on its assets by investing in the higher-yielding currency and hedging with currency swaps. 


Market Participants 

Sell Side 

Most of the major international financial institutions are willing to enter into currency swaps. However, the group of those institutions acting as market makers (that is, quoting firm buying and selling prices for swaps in all trading conditions) is limited to a handful of the most active swap participants who make markets for interest-rate swaps in the major currencies. Even this group is focused largely on swaps involving U.S. dollar LIBOR as one of the legs. Furthermore, because of the credit risk involved, many customers prefer only to deal with the highestrated institutions. In fact, most of the investment banking dealers book these swaps in special purpose, ''AAA''-rated, derivative product subsidiaries. 

Buy Side 

The end-users of currency swaps are mainly financial institutions and corporations. These firms can enter into a swap either to alter their exposures to market risk, enhance the yields of their assets, or lower their funding costs. 

Quoting Conventions 

Currency swaps are generally quoted in terms of all-in prices, that is, as absolute annual fixed percentage interest rates. Swap intermediaries may quote two all-in prices for each currency swap, for example, 6.86-6.96 percent for the U.S. dollar leg and 7.25-7.35 percent for the DM leg. This is a two-way price, meaning a dual quotation consisting of a buying and selling price for each instrument. The terms buying and selling can be ambiguous in the case of swaps; the terms paying and receiving should be used instead. In currency swaps, that is, fixed-against-fixed swaps, both sides of the swap should be specified. It may not be obvious which side of a two-way price is being paid and which is being received. 


Since the market for currency swaps is a highly customized OTC market, most of the trading is done by telephone. In negotiating swaps, key financial details are agreed on orally between dealers. Key details are confirmed in writing. 

In the early days of the swaps market, intermediaries tried to avoid the risk of acting as principals by acting as arrangers of swap deals between end-users. Arrangers act as agents, introducing matching counterparties to each other and then stepping aside. Arrangers were typically merchant and commercial banks. Arrangement continues to be a feature of currency swaps. Brokers act as agents, arranging deals by matching swap counterparties, but they do not participate in the actual transactions. Brokers do not earn dealing spreads, but are paid a flat fee based on the size of the deal. Brokers disclose indicative swap price information over networks such as Reuters and Telerate. 

The market for currency swaps has become more complex and diverse. Commercial banks have begun entering this market as principal intermediaries to provide their expertise in assessing credit risk to end-users of swaps. Many end-users lack credit analysis facilities and prefer having credit exposure to a large financial intermediary rather than to another end-user counterparty. However, in several cases, the credit rating of the financial intermediary is not strong enough for a particular end-user. For this reason, a large number of these swaps are booked in the AAA subsidiaries.

 The secondary market for currency swaps is more limited than the market for single-currency interest-rate swaps due to the credit risk involved. There are cases in which a buyer of a swap has assigned it to a new counterparty (that is, the buyer substitutes one of the original counterparties). Recently, assignment has been by novation, meaning that the swap contract to be assigned is in fact terminated and a new but identical contract is created between the remaining counterparty and the assignee. 

Market Transparency 

A large volume of currency swaps consists of customized transactions whose pricing is sensitive to credit considerations. Consequently, the actual pricing of these swaps is less transparent than it is for single-currency interest-rate swaps. Price information is distributed over screen-based communication networks, such as Reuters and Telerate, but this consists primarily of broker's indicative prices for plain vanilla cross-currency transactions. 


A currency swap is valued as the present value (PV) of the future interest and principal payments in one currency against the PV of future interest and principal payments in the other currency, denominated in the same currency:

The cash flows above (the streams of interest and principal payments) are functions of the current market exchange rate, which is used to translate net present values into the same currency, and the current market interest rates, which are used to discount future cash flows. Calculating the present value of the stream of fixed interest payments is done as follows:

where Vn = [1 + (day count/360 I)]n
and Cn = fixed interest cash flow at time n
P = principal cash flow
I = prevailing annual market interest rate
N = years to maturity
n = settlement period number
day count = number of days between regular coupon payments

For example, a $/DM currency swap is used with these specifications:
Remaining life = 3 years
$ fixed interest rate = 5% APR
DM fixed interest rate = 9% APR
$ principal = $100 million
DM principal = DM 170 million
Agreed-upon swap
exchange rate = 1.700 DM/$
Current prevailing rates:
3-year DM interest rate = 8% APR
3-year $ interest rate = 6% APR
Spot exchange rate = 1.5 DM/$

The PV of the deutschemark part of the transaction would be-
PV = DM 174,381,065.
To find the PV of the dollar cash flow, the
following constants are known:
N = 3 (years)
I = 6% APR

such that- 

PV = $97,326,988. 

The value of the swap is the difference between the PVs of the deutschemark and dollar cash flows. To calculate the difference, first convert the DM leg to dollar amounts, using the spot exchange rate of 1.5: 

(DM 174,381,065/1.50 =) $116,254,043 - $97,326,988 = $18,927,055. 

The pricing of currency swaps is similar to that used for interest-rate swaps, with the difference that the exchange rate has to be accounted for in assessing cash flows. A currency swap in which the two counterparties are both paying fixed interest should have a net present value of zero at inception. The fixed interest rate is set at inception accordingly. For a cross-currency swap in which at least one side is paying a floating interest rate, implied forward interest rates are used to price the swap. 


Currency swaps are used to manage interest-rate risk and currency risk. A company with mainly deutschemark revenues that has borrowed fixed-rate dollars is faced with the prospect of currency appreciation or depreciation, which would affect the value of its interest payments and receipts. In this example, the prospect of a dollar appreciation would mean that the DM revenue would have to increase in order to raise enough (stronger) dollars to repay the fixed-rate (dollar) loan. The German firm could hedge its exposure to the appreciating dollar by entering into a DM/$ currency swap. 

Furthermore, if the German company expects not only that the dollar will appreciate but that German interest rates will fall, then a cross-currency swap could be used. The German firm could swap fixed-rate dollars for floating-rate marks to take advantage of the expected fall in German interest rates, as well as hedge against exchange-rate risk. 

In the example above, initial exchange of principal is not needed. Exchange of principal is needed only when a swap counterparty needs to acquire foreign currency or needs to convert new borrowing from one currency to another. If the foreign currency of a liability is expected to depreciate (in the example above, if the dollar is expected to depreciate) or the domestic currency is expected to appreciate, a currency swap would restrict currency gains. In such cases, the only risk that would need to be hedged against would be interest-rate risk, in which case engaging in a domestic currency interest-rate swap would be appropriate. (In these hedges, assumptions must be made about the movement of the exchange rate. The swap counterparty is still exposed to exchange-rate risk, but is hedging only interest-rate risk based on an assumption about the exchange rate.) 


Market Risk 

A currency swap that is not hedged or used as a hedge exposes the institution to dual market risks: exchange-rate risk and interest-rate risk. Exchange-rate risk refers to movements in the prices of a swap's component parts (specifically, the spot rate), while interest-rate risk is caused by movements in the corresponding market interest rates for the two currencies. 

Liquidity Risk 

As stated earlier, the market for currency swaps is confined to a small number of institutions and is very credit intensive. Reversing out of a trade at short notice can be very difficult, especially for the more complicated structures. Occasionally, an institution can go to the original counterparty, resulting in the cancellation or novation of the trade, which frees up credit limits needed for some other transaction. 

Credit Risk 

Credit risk in currency swaps may be particularly problematic. Whereas interest-rate swaps involve the risk of default on interest payments only, for currency swaps, credit and settlement risk also extends to the payment of principal. The consequences of an actual default by a currency-swap counterparty depends on what the swap is being used for. If the currency swap is being used to hedge interest-rate and currency risk, the default of one counterparty would leave the other counterparty exposed to the risk being hedged. This could translate into an actual cost if any of those risks are actually realized. If the swap is held to take advantage of expected rate movements, the default of a counterparty would mean that any potential gains would not be realized. 


The accounting treatment for foreign-currency transactions, including currency swaps, is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 


The credit-equivalent amount of a currency-swap contract is calculated by summing- 

1. the mark-to-market value (positive values only) of the contract and 
2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are listed below. 

Remaining Maturity                   Factor 
One year or less                        1.00% 
Five years or less                      5.00% 
Greater than five years               7.50% 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, ''Capital Adequacy.'') For institutions applying market-risk capital standards, all foreign-exchange transactions are included in value-at-risk (VAR) calculations for general market risk. 


Currency swaps are not considered investments under 12 USC 24 (seventh). However, the use of currency swaps is considered to be an activity incidental to banking, within safe and sound banking practices. 


Balducci, V., K. Doraiswami, C. Johnson, and J. Showers. Currency Swaps: Corporate Applications and Pricing Methodology. Salomon Brothers, September 1990. 
Coopers & Lybrand. Currency Swaps. IFR Publishing, 1993. 
New York Foreign Exchange Committee. Guidelines for Foreign Exchange Trading Activities. March 1996. 
Smith, Clifford W., Jr., Charles W. Smithson, and D. Sykes Wilford. Managing Financial Risk. New York: Harper Collins, 1990. 
Schwartz, Robert J., and Clifford W. Smith, Jr., eds. The Handbook of Currency and Interest Rate Risk Management. New York Institute of Finance, 1990. 

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