A currency swap is defined as a financial contract between two parties, in which it is agreed to exchange resources or obligations of equal value, but in different currencies, within a specified period, through which the parties will respond to the payment of interest (reciprocally) corresponding to each obligation.
A currency swap in traditional banking is defined as a financial agreement, in which one of the parties agrees to cancel, on a reciprocal basis, a series of monetary flows, in exchange for receiving the same series of flows from the other part. These flows correspond to the payment of interest on the nominal of the Swap.
Example of how a currency swap Works
With this example we will be able to better understand how a currency swap works: An Italian company opens a business in the USA. and you will need dollars to build, buy materials from American suppliers and pay American operators, for this reason, you go to an Italian bank, present your project and request a loan in dollars, the representative of the Italian bank grants the loan in dollars and He goes to the Italian bank’s treasury to report the signing of a dollar loan agreement.
The Italian bank works with euros and therefore proceeds to exchange euros for dollars in the foreign exchange market, once this is done, it proceeds to send it to the Italian company, which each year will pay the interest in dollars to the Italian bank, who, at receiving them, change them to euros in the currency market, once the operation is finished, you will receive the interest and the principal of the loan, all in dollars.
Exchange rate and currency fluctuation
In general, there is some uncertainty regarding the currency exchange rate in each country, since many of these fluctuations are due to various external factors, the fact is that if halfway through the payment period (in the example mentioned above) the dollar loses value or the euro acquires more value, so the situation can play “for” or “against” one of the parties. In the example mentioned, if before with the interest received and changed to euros, the bank could have an interest number «X», now in this new scenario, the bank when changing the dollars to euros, will have an interest number «X / 2 “or half of the projected, if the situation is contrary (the dollar is revalued), the bank’s interest would be” 2X “or twice what was projected. To hedge against this uncertainty (regardless of what happens to the dollar or the euro), the treasury technician does what is called a Currency Swap.
The Italian bank has its treasury, that is to say, money in euros, and for its part, the American bank has its dollars, so the Italian bank technician communicates with the American bank and offers to formalize the currency Swap, through this swap, both banks agree to exchange dollars for euros for a certain period of time (at the agreed exchange rate). In this way, the Italian bank agrees to the exchange with the American bank, so that they coincide with the cash flows in dollars that the loan to the Italian company is generating. Now, if the two operations are combined, it can be seen that the Swap has covered the loan, and regardless of what happens to the dollar, the Italian bank will receive the euros at the exchange rate agreed at the time of the agreement.
At the beginning of the loan, the Italian bank exchanges the first flow of euros for dollars agreed with the American bank in the Swap contract, after which, it delivers the dollars to the Italian company through the loan contract. Subsequently, at the end of the first period, the Italian company pays the interest in dollars to the American bank, as contractually established. The American bank exchanges those dollars for euros with the Italian bank at the exchange rate that was previously set.
The same will occur in the second, third, fourth period, and at the end of the last period, the company will deliver the interest dollars of this last period and return the principal in dollars to the American bank, which, thanks to the Swap agreement, It will deliver them in exchange for euros, to the Italian bank, according to the exchange rate set at the beginning of the operation.
When an Italian company starts a project abroad, the correct thing is to request a loan in foreign currency from an Italian bank, which to satisfy its client (without exposing itself to the fluctuation of the currency markets), covers that loan with a currency swap formalized with a foreign bank.
Another example of Currency Swap
An Italian company opens a business in the US and instead of going to an Italian bank, goes directly to an American bank to request a loan in dollars, the bank offers the loan at 10% interest. On the other hand, there is an American company that opens a business in Italy and requests a loan in euros from an Italian bank, the Italian bank offers the loan at 10% interest.
The American bank meets the Italian company and decides to give the loan at 5% interest, and likewise, the Italian bank meets the American company and grants the loan at 5% interest. What these companies must do is sign a foreign exchange swap contract, and then take loans in their local currency with their bank, so that both companies will obtain the necessary financing, in the currency they need and at a lower interest rate.
What do you think about this topic? Do you have any other example of Currency Swap?
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