The application of currency swaps

The parties enter into currency swaps in order to hedge the currency risk from their assets or liabilities. As the swap runs for many years without any change in the exchange rate used, the currency hedging is long term. It is this long-term hedging of currency risk that makes currency swaps complementary to, and not in competition with, the forward exchange market.

An example of the mechanics of a fixed for fixed currency swap is given on pp. 344-6, and below an example is given of how a fixed for floating currency swap can be used to hedge the currency risk in new borrowings.

The application of a fixed/floating currency swap

Assume that company A wants floating rate French franc finance; it is not well known to the French capital markets, but well respected in the UK markets. Company B, on the other hand, is a French company that needs fixed rate Sterling funds but has substantial unused franc credit lines with its French bank.

An intermediary will arrange for company A to borrow in the UK bond market and swap the funds with B at the current spot rate. Company B will borrow the francs from its bank and pass these to A also at the current spot rate. The re- exchange of principals at the maturity of the swap ensures that the currency risk in the principals is completely hedged.

In addition to swapping the principals, the interest cash flows are swapped. Thus company A receives fixed rate Sterling cash flows and pays floating rate francs. Company B, on the other hand, receives floating rate francs and pays fixed rate Sterling.

The result is that company A borrows fixed rate Sterling and services the debt with Sterling cash flows from B, but gets floating rate francs to use. On the other side of the swap, B borrows floating rate francs, which it services with French franc cash flows from A, but gets fixed rate Sterling to use.

The application of interest rate swaps

Interest rate swaps have traditionally been applied to the reduction in borrowing costs for both parties by exploiting the comparative advantage that each party enjoys. The way in which the interest rate swap can be used to reduce the cost of funding has already been illustrated in the section on the mechanics of interest rate swaps.

However, interest rate swaps also have an important role to play in reconfiguring the cash flows of the parties, thereby enabling those parties to manage their interest rate risk. Thus, if a firm which originally issued fixed rate debt because it had cash inflows that were relatively insensitive to interest rate changes now finds that its receipts are very interest rate sensitive, an interest rate swap receiving fixed to pay floating will reduce the interest rate risk.

By entering into such a swap the firm will receive a fixed payment which will be applied to meet the fixed coupon payments on the bonds at issue. The firm will pay the floating coupon to the swap counterparty from its receivables which, because of their assumed interest rate sensitivity, will rise as the floating payment rises and fall as the floating payment falls.

Interest rate swaps are also used to hedge floating rate loans. Consider a corporate treasurer that has a floating rate commitment, the funds from which he or she expects to need for the next two years. Short-term interest rates are also expected to rise over this period and he/she would like to hedge out the risk of higher interest costs. By entering into a swap to pay fixed, the treasurer will receive the floating rate payment which will service the floating rate loan and, in return, will make fixed rate payments, thereby removing the uncertainty regarding higher interest rate costs in the future.

A similar transaction relating to a foreign currency floating rate loan and using a fixed for floating currency swap would remove the risk of paying higher foreign currency borrowing costs, due both to rising foreign interest rates and an appreciating foreign currency.

A swap to pay domestic fixed/receive foreign floating will effectively convert the foreign currency floating rate loan into a domestic currency fixed rate loan. This strategy would be appropriate if the treasurer expected both domestic and foreign rates to rise during the life of the loan, but foreign rates to appreciate relative to domestic rates, causing the foreign currency to appreciate relative to the domestic currency.

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