Everything seems to make sense about the mechanics/process of a currency swap except at initiation. Specifically, exchanging notional principals. It seems like each side receives the opposite principal that they need to actually hedge the original position. So if company A is paying fixed euro and needs a received fixed euro-pay floating swap, it looks like they initially get the opposite currency up front, not euros. Can someone clarify?
thank you!
Switching between fix/float would be an interest rate swap. This doesn’t require notional exchanges at initiation. The example you are talking about would be this. (A switching pay-fixed for pay-float in Euros)
Switching between currencies (ie Euro to USD) would be a currency swap, which would require a notional exchange (unless specified otherwise) and can be a combination of fixed/float pay/receive.
If company A’s domestic currency is, say, USD, and they have an obligation to make fixed EUR payments, then you’re correct, they may enter into a pay fixed USD, receive fixed EUR currency swap to avoid any exchange rate risk. They will pay the notional amount in EUR to the counterparty and receive the notional amount in USD. They’ll then make the periodic payments in USD and receive the periodic payments in EUR. Finally, they’ll return the USD notional amount and receive the EUR notional amount.
Easy-peasy.
“to hedge the original position” is not the primary reason to engage in currency swap. You could use a combination of other methods , a currency futures/forward sale or a currency option contract being some of them , to create a hedge.
Usually the currency swap is used to pay lower domestic interest rates , versus paying higher foreign interest rates .If you have a good credit rating in your own country but you are relatively unknown to banks in a foreign country , the curency swap could be a good way to save on interest rates.
But S2000, why would the domestic usd party pay euros and receive usd at initiation? How do they have euros to exchange and why would they receive usd if they’re based in the US, don’t they already have dollars? Having dollars doesn’t help them make their fixed euro payments?
Company A needs to pay out Euros on its obligation. To avoid the currency risk
get into a swap that pays them Euros - which they can use to pay back euros on their obligation.
how do they do that?
Advantage - you are still only doing transactions in USD - your local currency, and receiving Euros by way of the swap.
simple example: If you had to pay out 100 Euros each period and Euro rate is 5% - you need a loan of 100/0.05 = 2000 Euros. If current rate is 2 USD per Euro - you receive 4000 USD from other party, and pay them 2000 Euros (notionally).[This money never gets exchanged, - IT IS NOTIONAL].
Each period you pay interest on 4000 USD (this rate is decided when you enter into the swap - but you are paying ONLY in USD - so you incur no currency risk), and receive interest on 2000 Euro = 2000 * 0.05 = 100 Euro. (which you receive - pay your obligation off).
I would assume the us firm would buy the euro at the spot using the usd received at initiation.
The us firm entered a swap to pay usd/ receive euro because it had a pay euro obligation. Then for the swap (at initiation) it receives usd/pays euro. Essentially the us firm just switched a periodic pay euro obligation to a buy euro at initiation/ sell euro at maturity(for the notional principals). The us firm is still exposed to exchange rate fluctuations (only less frequent but still existing). Would the us firm enter a swap that doesn’t require notional principal exchanges then?
Thanks CPK. Always enjoy your insight. Guess I was scratching my head wondering what the US side did with the dollars they receive at initiation when their original obligation was in euros, but it sounds like its just theoretical (ie notional) and merely determines the USD amount they pay as part of the swap. Sound right?
thanks again
yup that cleared it up for me. thanks cpk!