Currency swaps, which were developed before interest rate swaps, were derivations of the 1970s practice of establishing parallel loans between two parties whereby, for example, company A would lend its domestic currency to company B, in return for a loan of company B’s domestic currency. These parallel loans were often used to manage exchange risk or to circumvent exchange control regulations.

This system of mutual lending had two serious drawbacks. First, there was no automatic off-set of the cash flows between parties. Thus, if company A defaulted on its loan from B, company B would still have to honour its commitment to A. Secondly, although the two loans effectively cancelled each other out, they were still shown on the balance sheets of each company.

The development of currency swaps specifically aimed to overcome these drawbacks. Although in currency swaps the principals are swapped and the full periodic currency payments are exchanged, the swap agreements provide for the right of setoff between the parties. The beneficial aspects of mutual set-off were also applied to interest rate swap agreements when these were developed in the early 1980s. Specifically only the net interest payments are transferred between the parties to an interest rate swap, thus reducing the exposure to credit risk.

The swaps market in its current form started in 1982 with a currency swap between IBM and the IBRD. This deal involved the IBRD paying the obligations on IBM’s Deutschmark and Swiss franc bonds, while IBM paid all the obligations on the IBRD US dollar bonds.

Since this transaction, the market for currency swaps has grown dramatically, but given the lack of exchange controls among the major currencies, one has to ask why currency swaps exist. Similarly, given the growing ease with which financial information can be transferred from one financial market to another, and the growing integration of the various capital markets, why have interest rates flourished so?

Currency swaps have developed as long-term instruments to hedge currency risk and are complementary to the shorter-maturity forward exchange market. The popularity of currency swaps is because they allow borrowers to exploit the advantages of borrowing in their domestic markets, yet obtain foreign currency finance.

With regard to interest rate swaps, until recently the accepted wisdom was that the market exists because some borrowers have a comparative advantage in one form of credit market — for example, the floating rate market — while others will have a comparative advantage in the fixed rate market. By borrowing in the financial market and/or country where each borrower has comparative advantage and swapping the interest flows on their respective loans, each party can get their desired form of financing, fixed or floating, more cheaply than if they tapped those markets where they have a comparative disadvantage.

Comparative advantage can be illustrated with the following example. Take the case of an AAA-rated borrower who can tap the 10-year euro-Sterling bond market at 75 basis points over the similar maturity gilt and can tap the bank loan market at LIBOR + 15 basis points. A BBB-rated borrower, on the other hand, will pay 200 basis points over the gilts but only 40 basis points over LIBOR. The AAA borrower has an absolute advantage in both markets, but a comparative advantage in the bond market where the yield differential is 125 basis points. The BBB borrower has an absolute disadvantage in both markets, but a comparative advantage in the bank loan market where the yield differential is only 25 basis points. As will be demonstrated later, if these two parties ‘trade together’, they can mutually benefit from this comparative advantage.

This comparative advantage is thought to exist because of the differing degrees of risk aversion between the bond market and the bank loan market, differing degrees of familiarity of name in different national markets or through regulatory restrictions on the free movement of capital.

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