MECHANISM OF CURRENCY SWAP
Feb 27 - Mar 4, 2012
A currency swap is a foreign exchange agreement between two parties to exchange aspects, namely the principal and interest payments, of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. Currency swaps are motivated by comparative advantage. Generally, a swap that involves the exchange of principal and interest in one currency for the same in another currency is considered to be a foreign exchange transaction and not required by law to be shown on the balance sheet. Since the exchange of payments takes place in two different currencies, the prevailing spot rate is used to calculate that payment amount. This financial instrument is used to hedge interest rate risks.
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling. While such restrictions on currency exchange have since become rare, savings are still available form back-to-back loans due to comparative advantage.
However, swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. After that, it becomes an important financial instrument for debt management and interest rate risk management. The swaps market was developed by, and is still dominated by, the major commercial and investment banks, which actively market their products and services to corporate, institutional and government clients.
Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more than $426.7 trillion in 2009, according to International Swaps and Derivatives Association.
In the 2000s, the trading of currency swaps increased noticeably for many currencies. In April 2004, there were only seven currencies in which turnover exceeded $400 million a day; in April 2007, there were 15 currencies with turnover above $400 million. Currency basis swap spreads for many currencies were positive over the 2005-07 periods and then turned negative in 2008.
During the global financial crisis of 2008, the currency swap transaction structure was used by the United States Federal Reserve and the central bank of a developed or stable emerging economy agreed to exchange domestic currencies at the current prevailing market exchange rate and reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps was "to provide liquidity in U.S. dollars to overseas markets".
While the central bank's liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term.
Even the People's Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, Belarus, Hong Kong, Indonesia, Malaysia, even with Pakistan and South Korea that perform a similar function to central bank liquidity swaps.
Currency swaps have two main uses, firstly, to secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back loan) and secondly to hedge against (reduce exposure to) exchange rate fluctuations.
Currency swap also used for managing risk and getting comparative advantage. Risk management is undeniably an important motivation for the general use of currency swaps. When either the operations or desired financial structure of a firm change, currency swaps are a cost-effective way to transform risk exposures and alter future cash flows.
Furthermore, comparative advantage is a more convincing motivation for swap-covered foreign currency borrowing. Indeed, central banks in countries with large volumes of swap-covered borrowing frequently cite comparative advantage as the key motivation for such borrowing. In financial markets, comparative advantage exists when the same risk is priced differently in different markets. If borrowing costs differ across markets, then issuers can reduce their overall financing costs by raising funds in the market in which each has a comparative cost advantage and swapping the proceeds.
Today, the benefits of currency swap are generally to help countries to regulate their exposure to interest rates. Speculators can benefit from a favorable change in interest rates and reduce uncertainty associated with future cash flows as it enables companies to modify their debt conditions. It can also reduce cost and risks associated with currency exchange. Industries having fixed rate liabilities can capitalize on floating - rate swaps and vise versa, based on the prevailing economic scenario.
On the contrary, there are also some drawbacks of currency swaps like it is exposed to credit risk as either one or both the parties could default on interest and principal payments. It is vulnerable to the central government's intervention in the exchange markets, this happens when the government of a country acquires huge foreign debts to temporarily support a declining currency. This leads to a huge downturn in the value of the domestic currency.
Pakistan signed currency swap agreements with China and Turkey. According to the government, the main objective of the accords is to firstly promote bilateral trade, secondly finance direct investments between the two countries in the respective local currencies of the two countries and thirdly use the agreement for any other 'purpose' as mutually agreed between the two central banks. Right now, it seems that the currency swap agreements may help Pakistan to improve trade with countries but they are unlikely to dent the demand of dollars that exert pressure on the rupee.