Currency stop is a special financial instrument that is used by both banks and institutional investors and international companies. Despite the fact that all types of swaps - currency, stock and interest rates - work approximately the same, the former have certain features.
An operation such as a currency swap always involves the participation of two market participants wishing to make an exchange to obtain the desired currency with maximum benefit. To illustrate the essence of a currency swap, consider the following conditional example.
Let a certain English company (company A) want to enter the US market, and American corporation (B) want to increase the geography of its sales in the UK. Typically, the loans and credits that banks give to non-resident companies are characterized by higher interest rates than those issued to local firms. For example, a company may be given a loan in American dollars at 10% per annum, and a company B - a loan in GBP at 9%. At the same time, rates for local companies are much lower - 5% and 4%, respectively. Firms A and B can conclude a mutually beneficial agreement between themselves, according to which each organization will receive a loan in its national currency at a local bank at more favorable rates, and then there will be an “exchange” of loans using a mechanism known as a currency swap.
Suppose that the British pound and the dollar exchange on the Forex market at the rate of 1.60 USD for 1.00 GBP, and each company needs the same amount. In this case, American firm B will receive 100 million pounds, and company A - 160 million dollars. Of course, they will have to compensate for the interest payments of their partner, but the swap technology enables both firms to reduce their costs of paying off the loan by almost half.
For the sake of simplicity, the role of a swap dealer acting as an intermediary between transaction participants was excluded from the example. The participation of the dealer will slightly increase the cost of the loan for both partners, but nevertheless the costs will be much higher if the parties do not resort to swap technology. The percentage that the dealer adds to the cost of the loan, as a rule, is not too large and is in the range of ten base points.
It should also be noted such a type of similar operations as interest rate swap. In this case, the parties exchange interest payments aimed at repaying foreign currency loans.
We note several key points due to which foreign exchange swap transactions differ from other types of such operations.
Unlike an income-based swap and an interest-based simple swap, a currency swap involves a preliminary and then final exchange of a pre-agreed amount of loan commitments. In our example, the companies exchanged $ 160 million for £ 100 million at the beginning of the operation, and at the end of the contract they have to make the final exchange - the amounts are returned to the relevant parties. At this point, both partners are at risk, because the initial exchange rate of the dollar and the pound (1.60: 1) has probably already changed.
In addition, netting is characteristic of most swap transactions. This term means offsetting cash. In a swap transaction of total income, for example, index income can be exchanged for income on a specific security. The income of one participant in the transaction is netted in relation to the income of another participant at a predetermined specific date, and only one payment is made. At the same time, periodic payments related to currency swaps are not subject to netting. Both partners undertake to make the relevant payments on the agreed dates.
Thus, a currency swap is a tool with which two main goals are achieved. On the one hand, they reduce the cost of obtaining loans in foreign currency (as in the above example), and on the other, they allow you to hedge the risks associated with sharp changes in the currency rate in the Forex market.