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Currency SWAP

What is a Currency SWAP ?

The currency swap is a dual exchange rate operation simultaneously, one spot, the other forward in the other direction, with the same compensation. The two compensation exchange similar flows labels in 2 different currencies. These 2 transactions are negotiated simultaneously with the same exchange rate as reference. Besides its function of an instrument of change, it is also a double treasury operation. Indeed, to buy for example $ spot against Eur (that we are selling) and to sell it forward against Eur that we are buying is equivalent in terms of flows as borrowing $ and lending Eur. This operation has a cost that will represent the interest rate differential between the 2 currencies. This difference is premium or discount.

The notion of premium and discount

The premium is a positive quantity (in addition to the spot). The future value is higher than the present value. Whoever buys the spot currency 1, he will sell it forward more expensive to offset the interest rate differential between the 2 currencies. Buying a currency 1 in premium compared to the currency 2 would make lose money to the buyer who is moving to a lower interest rate.

The discount is a negative quantity (which is removed to the spot). The future value is lower than the present value. Whoever buys the spot currency 1, he will sell it cheaper forward to offset the interest rate differential between the 2 currencies. Buying a currency 1 in discount compared to the currency 2 would make earn money to the buyer who is moving towards a higher interest rate.

We may therefore conclude that if interest rates on currency 1 are higher than interest rates of the currency 2, 1 is in discount compared to 2. Otherwise 1 will be in discount compared to 2.

Calculation of the swap

S=Spot*n*(r2-r1)/(1+t1)
S= Swap
N = Number of days
(r2-r1)= differential interest rate

The price of the swap can be also calculated from the forward and spot price by this calculation :

S = Forward price – spot

You therefore do this calculation twice to determine the bid / ask. Consider an example.
The spot on the EUR/USD is 1.2740 – 1.2743. The forward price is quoted 1.2710 – 1.2715.

The calculation is as follows :
Left hand side: 1.2740 – 1.2710 = -30
Right hand side: 1.2743 – 1.2715 = -25
When the swap points are more important left to right, both are assigned of a negative sign. Indeed, The Eur is in discount against the $ because rates in $ are below rates in E. The cotation of a swap is always made in point (pips).

The benefits of the swap

The foreign exchange swap has several advantages. First, it does not increase the size of the balance sheet. For companies it is a clear advantage over classical lending or borrowing. Swaps are a promise / commitment to repurchase / resale of currencies at a future date. For companies, it will prevent that certain ratio reports as capital / total assets of the balance sheet came to degrade their rating by the rating agencies.

The swap also offers a very important liquidity.

Finally, the two compensations can build a currency swap by agreeing on all the features such as maturity, amount, price. It is therefore a very flexible tool.

In practice

The currency swap is an exchange of debts between two compensation. The operation takes place in 2 stages:

– Exchange of capital: the two compensation traded the nominal amount of their respective debts or deposits. This is the spot that serves as a reference to the operation which is a spot operation
– Payback of capital: at the maturity, the two compensation exchange interest and the value of their loan or deposit in a currency against its value in another currency.

It is therefore really a treasury operation with payment of the capital in spot date and payback of the capital and interest at maturity.

There is also another type of swap that works the same way, the cross-currency swap in which we exchange interest rates of a medium or long term denominated in two different currencies. For example, there may be an exchange of 3 months USD against 6 months EUR.

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