06-01-2014, 04:46 PM
Currency Swap Basics
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Introduction To The Forex Market
A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional exchange, periodic cash flows are exchanged in the appropriate currency.
Purpose of Currency Swaps
An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from Brazilian banks' unwillingness to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable interest rate in the U.S. market. The Brazilian Company may only be able to obtain credit at 9%.
While the cost of borrowing in the international market is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities. (This emerging market is making strides in regulation and disclosure. See Investing In China.)
Setting Up the Currency Swap
Based on the companies' competitive advantages of borrowing in their domestic markets, Company A will borrow the funds that Company B needs from an American bank while Company B borrows the funds that Company A will need through a Brazilian Bank. Both companies have effectively taken out a loan for the other company. The loans are then swapped. Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both Companys require the same equivalent amount of funding, the Brazilian company receives $100 million from its American counterpart in exchange for 160 million real; these notional amounts are swapped.
Advantages of the Currency Swap
Rather than borrowing real at 10% Company A will have to satisfy the 5% interest rate payments incurred by Company B under its agreement with the Brazilian banks. Company A has effectively managed to replace a 10% loan with a 5% loan. Similarly, Company B no longer has to borrow funds from American institutions at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty. Under this scenario, Company B actually managed to reduce its cost of debt by more than half. Instead of borrowing from international banks, both companies borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap.