Rate swaps are agreements that are made between two different corporations or companies to exchange cash flows based on a particular variable. Most of the time, this variable is an interest rate, but it can also be an equity price, foreign exchange rate, or a commodity price. These swaps allow companies to reduce the amount of risk the private parties experience in the market.
Swaps are not instruments that are exchange-traded, but rather contracts that are traded as over-the-counter derivatives in the market. Because of this, the majority of those who use interest rate swaps are financial institutions and firms, with very few individuals participating in this risk management strategy.
The majority of the time, there are two basic exchanges that are used by corporations and companies: plain vanilla interest rate swaps and currency swaps. In other articles, we have discussed the main features and benefits of a plain vanilla swap, but today we are going to be discussing currency swaps. In the following, you will learn what currency swaps are and how they differ from plain vanilla interest rate swaps.
Currency Swaps vs. Interest Rate Swaps
The definition of a currency swap is basically the same as any other rate swap. However, there are a few unique differences between the two. One of the biggest ones, however is the fact that this type of swap allows for the exchange of principal.This means a company can actually exchange one debt for another. Often times this is done because a company can reduce its potential risk by obtaining a debt in a different currency.
There are three ways a currency swap can be used, because of this monumental difference.
- Exchange Principal Only- The most basic swap that can occur is one that involves principle only. Both parties agree to exchange their debt, which are often two different types of currencies in an effort to fix forward rates in a cost effective way. This type of exchange by itself is often called a FX-swap.
- Principal and Interest- Currency exchanges differ from regular rate swaps because they allow for the exchange of both principals and interest rates. Another difference, when both are exchanged in this method, is that unlike a plain vanilla swap, cash flows from interest aren’t netted before the counterparty is paid because of the difference between the two currencies that are exchanged. This kind of exchange is often called a back-to-back loan.
- Interest Only- As with a plain rate swap, currency swaps do allow for interest only swaps. Like before, however, cash flows cannot be netted before they are given to the counterparty because of the different currencies used. This type of exchange is often called a cross currency swap.
While currency swaps aren’t always the right choice for company who might benefits from alternative derivatives, they can sometimes be an excellent solution when different currencies are used and plain vanilla rate swaps simply don’t work.
If you need to manage your risk and want to exchange loans, consider what type of exchange you could benefit from the most. Each have their advantages, but differ in their abilities.