Currency Swap Definition, Importance, Advantages, Disadvantages, Example, Types & Overview

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Definition: Currency Swap

Currency swap is the exchange of interest or principal in one currency for the same in another currency. Currency swapping is where interest is paid on an equal principle in their respective currencies and their difference. It is otherwise known as cross currency swap.

A currency swap comprises of three stages:

i. At the starting of the swap, the principal amount is traded at spot rate.

ii. During the progressing timespan of the swap, the interest is paid on the swapped loan amount.

iii. At the end of the swap, the loan amount is swapped back to a predominant spot rate or sometimes to a pre-concurred rate chose at the starting of the process.

Types of Currency Swap

The different types of currency swaps are as follows:

1. Fixed to fixed currency swap- It is the exchange of fixed interest rate on a credit in one currency for fixed interest rate on an equivalent credit in another currency.

2. Fixed to floating currency swap- It is the exchange of fixed interest rate on a credit in one currency for floating interest rate on an equivalent credit in another currency.

Currency Swap

Importance of Currency Swaps

Currency swaps helps the foreign companies to take loans in other countries at a better interest rate than it could obtain by borrowing directly in that country. Currency swap allows a company or a customer to re-denominate a principal amount from one currency to another. Re-denomination lowers the borrowing cost for debt and protect the exchange risk involved.

Advantages of Currency Swap

Some advantages of currency swaps are:

1. Companies can use currency swap to raise funds in one currency to save in other currencies.

2. Companies can change their loans from one currency to another currency.

3. Currency swap offers adaptability to corporate who want insurance against risk associated with one currency.

4. Reduce expenses and risk associated with exchange rate.

5. A company can enter into a money swap at any time during the life of a transaction.

6. Early termination of swap contracts is possible by agreement of both parties.

Disadvantages of Currency Swap

Certain disadvantages of currency swaps are:

1. Parties are prone to credit risk as one or either party could default on interest and principal payments.

2. There may be central government intervention in the exchange markets.

3. The process of setting up currency swap agreement might be expensive in terms of fees charged by intermediary.

Example of Currency Swap

An American company can borrow in dollar in United States at the rate of 5.25%. It wants to make an investment in India in rupee where the relevant borrowing rate is 14%. Similarly, an Indian company can borrow in India at the rate of 9.45%. It wants to finance a project in United States in dollars where direct borrowing rate is 11%. In this case, the American company can borrow U.S dollars for 5.25%, then it can lend the money to Indian company at same rate. Similarly, the Indian company can borrow rupee for 9.45% and lend it to American company at the same rate. Both the parties will benefit by the currency swap.

Hence, this concludes the definition of Currency Swap along with its overview.

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