CURRENCY SWAP:
- Currency swap is an agreement between two cross-border entities where one of them agrees to provide a loan to another in a foreign currency.
- These entities can be either companies, countries or the central banks
- The repayment takes place in foreign currency/Dollar at a fixed date and a pre decided Exchange Rate
- The interest rate charged on such loans is usually lesser than that available in the foreign market.
Currency swap between Companies:
Let us take the example:
- US-based company XYZ Inc. which can borrow in the US at an interest rate of 5%, but the company requires a loan in Pound sterling for investment in the UK, where the prevailing interest rate is 8%.
- At the same time, a UK-based company ABC is willing to invest in a US project but funds to ABC in US are available at 9% in comparison to the UK’s 6% interest rate.
- Company XYZ & Company ABC can benefit by entering into a fixed-for-fixed currency swap contract.
- US-based company XYZ Inc. ------ Borrow a US dollar loan at 5% in US ------------Lend the proceeds to the UK-based company ABC Plc. at that rate.
- UK-based company ABC Plc. -------Borrow a Pound sterling loan at 6% -------------Lend it to the US-based company XYZ Inc.
Win -Win Situation for Co. XYZ Inc. & Co. ABC Plc.:
XYZ Inc. saved 2% (= 8% – 6%) in interest rate, while ABC Plc. saved 4% (= 9% – 5%). This is how the participating parties benefit from a currency swap.
How Bilateral Currency Swap between central banks works:
- Currency Swap was very much popular During the financial crisis -2008 as banks were reluctant to lend to one another because of the financial uncertainty.
- This resulted in the increase in the cost of borrowing, as lenders demanded higher interest rates to compensate for rising counterparty risk.
- This issue was very critical in case of Foreign Currencies as developing countries were looking for Dollars for trade.
- In the example, there is currency Swap between USA and Sri Lanka.
- USA provide Dollars in Jan 2024 with commitment to give it back on Jan 2029 with predefined Exchange Rates and date.
