Exchange rate swaps are contracts for the exchange of cash flows between two different companies or companies based on a specific variable. Often it is a variable interest rate, but it can also be the price of capital, the foreign exchange rate, or the price of a commodity. These swaps allow companies to reduce the amount of risk that private parties face in the market.
Swaps are not instruments traded on the stock exchange, but contracts sold on the market as over-the-counter derivatives. For this reason, the majority of interest rate changers are financial institutions and companies, and very few people participate in this risk management strategy.
Often, there are two main exchanges used by companies and firms: regular vanilla interest swaps and currency swaps. In other articles, we have discussed the main features and benefits of plain vanilla swaps, but today we will discuss currency swaps. Below, you will learn what currency swaps are and how they differ from simple vanilla interest swaps.
Currency swaps and interest rate swaps
The definition of a currency swap is basically the same as other exchange rate swaps. However, there are some unique differences between the two. One of the biggest ones is that this type of swap allows for a major debt exchange, ie one company exchanges one debt for another. This is often because the company is able to reduce potential risk by borrowing in a different currency.
Because of this monumental difference, there are three ways to use a currency swap.
- Just a basic exchange The most basic exchange that can take place is an exchange that covers only the principle. Both parties agree to change their debts, which are often two different currencies, in order to adjust forward rates to their advantage. This type of exchange itself is often called currency exchange.
- Principal and interest Currency exchange differs from ordinary interest rate swaps in that it allows you to change both base and interest rates. Another difference is that, when both are exchanged in this way, unlike a simple vanilla swap, the cash flows from interest are not net due to the difference between the two currencies exchanged. Such exchanges are often called back-to-back loans.
- Only interest- As with regular exchange rate swaps, currency swaps only allow interest rate swaps. As before, cash flows cannot be netted before they are transferred to the other party because the currency used is different. This type of exchange is often called currency exchange.
While currency swaps are not always the right choice for companies that may benefit from alternative derivatives, they can sometimes be an excellent solution when different currencies are used and simple vanilla swaps do not work.
If you need to manage your risk and want to make a loan exchange, think about which type of exchange you can get the most out of. Each has its advantages, but differs in its abilities.