What is Currency Swaps?
A Currency Swap, also known as a forex swap or FX swap, is a financial derivative contract between two parties that involves the exchange of one currency for another with an agreement to reverse the exchange at a future date. Currency swaps are used to hedge against exchange rate fluctuations, obtain foreign currency financing at more favorable rates, or simply to optimize the currency composition of assets and liabilities.
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In interest rate swaps, the currency of interest payments is the same for both fixed and floating interest loans. It is also possible to swap loans, which are raised in different currencies. Currency swaps allow the exchange of cash flows arising out of two loans that are denominated in different currencies. Since currencies are different, there is a need to exchange the principals at the swap termination date. Hence, the principal amount is not notional in the case of currency swaps. The exchange of principal at the beginning is optional as it does not affect swap calculations.
Currency swaps might involve the exchange of fixed to fixed interest payments, fixed to floating or floating to floating interest payments. Currency swaps can be used to hedge both currency and interest rate exposures. They provide all advantages mentioned in the case of IRS, like asset-liability management, lowering the cost of borrowing and interest rate risk management, apart from allowing the hedging of currency risks.
Consider an Indian company that has revenues in Euro but could raise loans cheaper in the US dollars. It can raise US dollar denominated loans and swap it with a loan denominated in Euro through currency swaps. Let the amount required by the Indian company be EUR 10 million for three years and the spot exchange rate be EUR/USD 1.12.
The company can approach a bank for structuring a currency swap. The swap will involve the following steps:
- The company will raise a three-year loan of $11.20 million in Euro markets, at say 4% fixed rate.
- The bank will quote a swap rate, say 5%, applicable for three-year USD:EUR swaps based on yield curves.
- As per the currency swap terms, the company will exchange the principal with the bank and receive EUR 10 million, since it requires the amount in Euro.
- The company will make interest payments on EUR 10 million at the swap rate of 5%.
- The bank will pay 4% interest on $ 110.2 million, which will be used by the company to service the USD loan.
- On maturity of the loan after three years, the company will repay EUR 10 million to the bank. The bank will pay $110.2 million to the company, which will be used to close the dollar loan.
The above swap deal allows the company to convert its dollar liability into Euro liability in tune with its revenues thereby eliminating the exchange rate risk. Currency swaps can also, involve fixed to floating or floating to floating swaps. It could also be based on a comparative advantage of firms.
For example, if the above company can raise cheaper dollar loans in the floating rate market and is also interested in the floating rate liability in Euro, then it can structure a EUR-USD currency swap with floating to floating exchange of interest payments. The reference rate will be LIBOR for the US dollar loan and EURIBOR for the loan denominated in Euro. Such swaps where both the legs have floating rates are termed ‘Basis Swaps’.
Types of Currency Swaps
Currency swaps can also be of following types:
- Coupon Only Swaps (COS): In this case, the swap deal is structured to exchange only coupons between two currencies.
- Principal Only Swaps (POS): Here, the only principal is exchanged at a future date, similar to the exchange of bullet loans and is equivalent to a foreign exchange forward contract.
Illustration: Two firms X and Y are planning to borrow in sterling and dollars respectively. They face the following interest rates in Eurodollar and Euro-sterling markets:
| Eurodollar | Euro-sterling | |
|---|---|---|
| Firm X | 7% | 9.5% |
| Firm Y | 9% | 10% |
Explain how a currency swap can be structured (assume the spot exchange rate of USD-GBP 1.2).
Solution: The borrowing cost is higher in both dollar and sterling markets for Firm Y when compared to Firm X. However, it has a comparative advantage in the Euro-sterling market. While Firm X has to pay 2.5% extra in sterling markets when compared to the dollar market, Firm Y’s cost will be higher only by 1%. The two firms can use this fact to structure a currency swap that brings down the borrowing cost for both the firms. Since Firm Y has a comparative advantage in the sterling market, it will borrow in the sterling market at 10%. Firm X will borrow in the Eurodollar market at 7%.
Firms can then swap loans by splitting the comparative advantage. Since the Firm X has an overall advantage in both the markets, in order to derive additional benefit, it would pay lesser than the rate applicable for it in the sterling market.
Steps in Swap
- X will borrow $1 million and Y will borrow GBP 1.2 million. The two firms will exchange principal at the spot exchange rate of 1.2 at the start of the contract.
- The Firm X will pay 9% on sterling principal to Firm Y (or a swap intermediary) on each interest repayment dates. This is less than 9.5% if it has raised sterling loan by itself.
- Firm Y will pay 7% on the dollar principal to Firm X (or a swap intermediary) on the same date. This is less than 9% it would have to pay if it has raised dollar loan by itself.
- Firm X will use 7% received from Y to pay-off its dollar loan. Firm Y will use 9% received from X along with its own additional 1%, to pay-off its sterling loan. Thus, effective interest applicable for X is 9%, while for Y it will be 7% on dollar principal and 1% on sterling principal.
Cost savings for X = 0.5% on sterling loan
Cost savings for Y = 2% on dollar loan (However, it has to pay 1% additional on sterling loan).
Swaps in Indian Scenario
The interest rate and currency swap markets in India are very small as compared to swap markets in developed financial markets. For interest rate swaps, the equivalent of LIBOR in Indian financial markets is NSE-MIBOR for rupee. It is the Mumbai Interbank Offered Rate which is the inter-bank interest rate for deposits in rupee applicable between commercial banks in Indian money markets.
Apart from NSE-MIBOR, other benchmarks related to swap markets in India are:
- FIMMDA – NSE Mumbai Interbank Tom Offered Rate (MITOR) – It is calculated from the overnight USD interbank offer rate and annualised cash-tom premium.
- FIMMDA – Thomson Reuters Mumbai Interbank Forward Offered Rate (MIFOR) –– It is calculated as a sum of USD LIBOR rate and the forward premium percentage for relevant maturity.
- FIMMDA – Thomson Reuters Mumbai Interbank Overnight Indexed Swaps (MIOIS) – It comprises fixings of OIS rates for 11 tenors as polled by Reuters.
- FIMMDA – Thomson Reuters Mumbai Interbank Offered Currency Swaps (MIOCS) – This comprises fixings for MIFOR rates ranging from 2 to 10 years for five tenors ranging as polled by Reuters.
All the above benchmarks are published by FIMMDA and determined through polling of quotes by active banks by Thomson Reuters.
Overnight Index Swaps (OIS)
OIS swaps are the most popular interest rate swaps in the Indian interbank market. OIS is the fixed to floating interest rate swap and can be based on Overnight MIBOR (or MIOIS). If Bank A enters into an OIS for a notional principal of INR 5 crore with another Bank B for 5 days, Bank A will pay Overnight MIBOR rate on the notional principal and will receive a fixed rate as per the swap deal (say 7%). In OIS, interest payments are not exchanged on a daily basis but compounded.
Suppose Overnight MIBOR is given in Table 10.8, the final settlement amount after five days can be calculated as follows:
| Notional Principal | Overnight MIBOR | Floating Interest Payable | |
|---|---|---|---|
| Day 1 | 5,00,00,000 | 6.50% | 8904 |
| Day 2 | 5,00,08,904 | 7.00% | 9591 |
| Day 3 | 5,00,18,495 | 6.80% | 9319 |
| Day 4 | 5,00,27,813 | 7.10% | 9731 |
| Day 5 | 5,00,37,545 | 7.50% | 10282 |
| Total Interest | 47826 |
The total compounded interest payable for the floating leg is INR 47,826, which is a summation of the daily-compounded interest. The total compounded interest payable for the fixed leg at 7% will be:
Interest on fixed leg = 5, 00, 00, 000 × (1+7%/365) ^ 5 – 5, 00, 00, 000 = INR 47,964
The net settlement amount at the end of the swap period will be INR 137 to be paid by Bank B (Fixed rate payer) to Bank A (Floating rate payer).
Currency Swaps in India
As per RBI regulations, Indian banks can run swap books with INR as one of the currency legs. If they offer other currency swaps (without INR leg), it has to be covered with an overseas bank on a back-to-back basis. Banks in India hedge their currency swaps on the basis of overall forward positions on respective currencies and the asset/liability position of their banking book.
