# Currency swap

A currency swap is an OTC derivative that consists of an agreement to exchange cash flows between two parties, with the peculiarity that each flow is denominated in a different currency. That is, it is the simultaneous sale of one currency for another.

They are derivative products, since they are subject to the evolution of currencies. They are also known as "currency swaps".

## Currency swap scheme

The operation takes place in three phases:

• At the beginning: On the value or start-of-life date of the operation, the two companies exchange the nominal value of their respective debts under the spot or spot exchange rate, which serves as a reference for the operation.
• During the life of the swap: The cash or interest flows, denominated in different currencies, are exchanged at an exchange rate previously agreed between them.
• At maturity: The nominal amount and the pending interest are exchanged again and the operation is extinguished.

For example, two companies contract a currency swap of € and \$ whose validity will be 15 years, through which they will exchange a nominal of 10 million currency units and 100,000 currency units every 3 months. A will pay the € and B will pay the \$ and the amounts will be calculated according to the exchange rate agreed in advance between the two companies. At maturity, the 10 million are returned, respectively.

Banks often use swaps to hedge their balance sheet positions.In particular, they tend to have very high amounts in interest rate swaps and resort to currency swaps when they have debt denominated in another currency.

## Elements of currency swaps

A currency swap reflects an agreement for the regular exchange of money flows between two companies. It is still a contract to exchange debt, so you must collect the terms in which the agreement is closed before the life of the swap begins.

Since they are OTC derivatives, the two participating companies make currency swaps - and all swaps, in general - according to their needs. That is, they negotiate the terms and conditions and lead to a personalized product.

• Start and end date: These dates define the validity period of the swap and indicate the exchange of the nominal or principal between the counterparties.
• Nominal or principal: It is the amount of money on which the interest to be exchanged is calculated. As we have seen, companies also exchange nominals. These amounts are determined in their corresponding currency according to the agreed exchange rate.
• Exchange rate for the entire life of the swap: For the nominal value and interest of each counterparty. It can be a fixed rate, a floating rate, or a mix.
• Foreign exchange.
• Frequency of payments: It is usually common to set quarterly payments.
• Basis for calculating the flows.

In OTC financial derivatives in Spain, it is usually required to sign a CMOF (Framework Contract for Financial Operations) between the entities. Determine what the contract consists of, the obligations of the parties, the rules on payments, interest, dates, etc. In the United States, this contract is called ISDA (International Swaps and Derivatives Association). They promote market integrity and limit market risk.

## Structure of currency swaps

The structure of swaps can be of three types:

• Fixed rate: The companies agree to quarterly payments on the nominal of the operation defined by a fixed rate previously agreed between both. For example, two companies set a fixed rate of 1.16 EUR / USD for the entire life of the swap. If this rises to 1.19 EUR / USD, the company that pays euros will have losses, and vice versa.
• Variable rate: The companies agree to quarterly payments on the nominal of the operation defined by a variable rate previously agreed between both. For example, a reference rate, such as Euribor, Libor, etc., previously agreed.
• Fixed and variable rate: The companies agree that one of them pays a fixed rate in exchange for receiving a variable rate from the other. For example, one pays a fixed rate of 1.16 EUR / USD and the other a reference rate.

## Swap profit

They are very liquid instruments, made to measure and serve to reduce financing costs, optimizing the debt structure. In fact, swaps exist to make perfect hedges that other financing products, such as banking, for example, are not capable of offering. Its main uses:

• Exchange rate risk coverage and mitigation: As protection against exchange rate fluctuations. For example, to pay debt denominated in foreign currency, such as foreign bonds. Companies use currency swaps when they issue this class of bonds to finance international projects. Foreign bonds are denominated in the market currency of the country where they will be traded, so they will seek a swap with a fixed exchange rate that finances the payment of interest and the principal of the debt and, in exchange, they will pay national currency. This type of currency swap is called a cross-currency swap.
• Obtain financing cheaper than that offered by the foreign market, exchanging debt with companies in that market.
• Speculation for profit.

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