Definition of 'Foreign Currency Swap' An agreement to make a currency exchange between two foreign parties.

The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency. The Federal Reserve System offered this type of swap to several developing countries in 2008. Investopedia explains 'Foreign Currency Swap' The World Bank first introduced currency swaps in 1981 in an effort to obtain German marks and Swiss francs. This type of swap can be done on loans with maturities as long as 10 years. They differ from interest rate swaps because they also involve principal. A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage.[1] A currency swap should be distinguished from a central bank liquidity swap. Originally, currency swaps were used to give each party access to enough foreign currency to make purchases in foreign markets. Increasingly, parties arrange currency swaps as a way to enter new capital markets or to provide predictable revenue streams in another currency. *** Central bank liquidity swap is a type of currency swap used by a country's central bank to provide liquidity of its currency to another country's central bank. *** A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate(s) of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk. *** In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward). *** comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (absolute advantage in all goods) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies. Structure Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal. [1] There are three different ways in which currency swaps can exchange loans: 1. The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a

counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.[2] 2. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.[2] 3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross currency swap.[3]
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An interest rate swap (IRS) is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. [1] Interest rate swaps are commonly used for both hedging and speculating. Uses Currency swaps have two main uses:

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).[2] To hedge against (reduce exposure to) exchange rate fluctuations.
[2]

Hedging example For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following:

If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency. Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.

Currency swaps are agreements between two individuals or entities to exchange specified types and amounts of currencies. Along with the initial exchange of a specific amount of one currency for a specific amount of a different currency, the process of a currency swap normally also includes a series of recurring payments based on the cash flow performance of the two currencies. This makes a currency swap somewhat different from a currency exchange, in that the exchange normally involves simply exchanging currency at the most recent rate of exchange. The recurring payments that compose the second phase of a currency swap normally make use of both fixed and variable rates of interest. One party will agree to pay a fixed interest rate, while the second party will make interest payments based on a floating rate of exchange. However, it is possible to arrange a currency swap agreement where both parties pay recurring payments based on a fixed rate or a floating exchange rate. The final determination of how the interest rate will be calculated is defined in the terms and conditions that govern the swap. One important aspect of the currency swap that also sets it apart from currency exchanges is the fact that the swapping of the currency is not a permanent component. At the time that the two currencies are swapped, the parties agree to make the recurring interest rate payments for a specific period of time. Once the duration outlined in the agreement is complete, the two currencies are returned to the original owner. However, each party retains all returns that were shared in the form of interest payments. The transaction of a currency swap is usually utilized when there is some expectation that the two currencies in question have potential to realize a significant amount of return via the rates of interest accrued. As can be expected, both parties usually anticipate realizing a higher return with the currency type that is received in the swap. However, since rates of exchange tend to fluctuate over time, there is usually a reasonable chance that both parties ultimately benefit from the currency swap.

Question:

A Canadian company enters into a currency swap with a US company for a period of 4 years. At the beginning they exchange 1M USD for 1.1M CAD. The Canadian company will pay fixed rate and US company will pay the variable rate at the beginning of each period. What will happen at the end of the 2nd year, given that:

Initial Fixed Rate t=0 Fixed Rate at the beginning of the 2nd year (t=1) Variable Rate at t=0 Variable Rate at t=1 Variable Rate at t=2

3% 4% 2% 4% 3%

This question is testing if you know how currency swap works and also what interest rate to use in the calculation.

The process of a currency swap is the following: 1. At beginning, exchange principals Canadian company gives 1.1M CAD and receives 1M USD and vice versa

2. At the end of each period, exchange interest for the borrowed currency Canadian company pays US company the interest for 1M USD and vice versa

3. At the end of the swap, return principals Canadian company gives US company back the 1M USD and vice versa

One must note that for the fixed-rate payer, it will use the fixed rate at the beginning of the swap to calculate the interest to pay at the end of each period. Therefore, for the Canadian company, it will use 3% as the interest rate however it changes subsequently. So the Canadian company will pay 0.03 * 1M USD = 30k USD at the end of the 2nd year.

For the variable rate payer, they will use the variable rate at the beginning of each period. So, they will use 4% to calculate the interest to pay at the end of the 2nd year. So the US company has to pay 0.04 * 1.1 CAD = 44k CAD. Currency Swap Agreement on wiseGEEK:

The process might be expensive in terms of fees charged by an intermediary or the cost of management time in negotiation. There also will be legal fees for drawing up the currency swap agreement. The expenses of setting up a currency swap might make it unattractive as a hedging mechanism against currency movements in the short term. One party will agree to pay a fixed interest rate, while the second party will make interest payments based on a floating rate of exchange. However, it is possible to arrange a currency swap agreement where both parties pay recurring payments based on a fixed rate or a floating exchange rate.