Currency swaps involve exchanging principal and interest on a loan in one currency for another to hedge against currency fluctuations and increase future cash flow certainty. They can also provide lower interest rates, but costs and default risks are disadvantages. Swaps can involve only principal or interest, and finding a willing counterparty can be expensive. Currency swaps can be profitable in the long term but carry the risk of the other party breaching the agreement.
A currency swap occurs when two parties agree to exchange the principal and interest on a loan in one currency for the principal and interest on a loan in another currency. The intent of the exchange is to hedge against currency fluctuations by reducing exposure to the other currency and increasing the certainty of future cash flows. A company could also achieve a lower interest rate by seeking a low-interest loan in another currency and participating in a currency swap. The costs involved in arranging the transaction can be a disadvantage, and as with other similar transactions, there is also the risk that the other party to the exchange may default.
A structure often used in a currency exchange includes only the principal of the loan in the agreement. The parties agree to change the principal of their loans at a specified time in the future at a specified rate. Alternatively, the loan principal swap could be combined with an interest rate swap, whereby the parties would also swap the interest streams on the loans.
In some cases, the currency exchange would relate only to the interest on the loans and not to the principal. The two streams of interest would be exchanged during the term of the agreement. These interest streams are in different currencies, so the payments would generally be made by each party in full, rather than being offset in a single payment, as might be the case if only one currency is involved.
The advantage of currency swaps is that they bring together two parties, each of which has an advantage in a particular market. The agreement allows each party to exploit a comparative advantage. For example, a domestic company might borrow on more favorable terms than a foreign company in a particular country. Therefore, it would make sense for the foreign company entering that market to seek a currency swap.
Costs that can arise for a business seeking a currency swap include the expense of finding a willing counterparty. This can be done through the services of an intermediary or through direct negotiation with the other party. The process can be expensive in terms of fees charged by a broker or the cost of handling time in the negotiation. There will also be legal fees for drawing up the currency exchange agreement.
The expense of setting up a currency swap could make it unattractive as a hedging mechanism against short-term currency movements. In the long term, where there is higher risk, the swap could be profitable compared to other types of derivatives. One drawback is that, in any such agreement, there is a risk that the other party to the contract may breach the agreement.
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