Over the last three months we have examined the ways in which foreign exchange risk arises. In this article we show how treasurers can use currency swaps to manage their company’s exposure to foreign exchange risk. We illustrate how a typical currency swap works and identify some of the legal issues surrounding their use. The article concludes with an analysis of the costs and benefits of using currency swaps to manage interest rate risk.

Foreign exchange risk management

In Treasury Today May 2002, we identified the types of foreign exchange risk that a company might be exposed to – transaction, translation and economic risk. The treasurer will have a range of alternative actions available to manage any foreign exchange exposure, but the decision taken must be in keeping with the board’s policy on acceptable risk. This policy should form part of the company’s treasury policy and will include a statement of whether trading in derivatives is allowed.

When faced with a foreign exchange exposure, a company has three broad choices on the course of action it can take:

1. Do nothing.

   If the company is happy with the level of exposure, it may decide to do nothing to actively manage it. For relatively small exposures, this is often prudent as proactive action will impose a cost on the company.

2. Hedge naturally.

   For example, an exposure to make repayments on a foreign currency loan might be used to offset future receivables in that currency.

3. Take action to manage the exposure.

   There are a number of methods available to hedge a foreign exchange exposure for which no natural hedge is available. The suitability of each method depends on the nature of the exposure (how it arose and the length of the exposure) and the risk appetite of the company.

What is a currency swap?

A currency swap is an agreement between two parties to exchange a series of cash flows denominated in one currency for those denominated in another for a predetermined period of time. This involves the swap of the currency amounts for an agreed period and payments of interest during that period.

Unlike an interest rate swap, a currency swap requires the actual exchange of the two principal currency amounts on which the sets of cash flows are based. An exchange takes place at the beginning of the arrangement and at maturity the amounts are swapped back. This actual exchange of principal is an important feature of a currency swap because, although the two amounts exchanged at the beginning of the agreement may be of equivalent value in the market, it is unlikely (as a result of movements in the exchange rate) that this will be the case at maturity. This means there is a residual counterparty risk that remains after the currency swap has been agreed.

The uses for a currency swap

Currency swaps originated partly as a means for UK companies to avoid exchange controls in the 1960s and 1970s. Despite the abolition of exchange controls, currency swaps are still popular instruments for hedging foreign exchange exposures. They are typically used by companies needing to hedge a long-term liability that is denominated in a currency other than their main operating currency. Because an exchange of principal is part of the currency swap, the transaction will be recorded on both parties’ balance sheets. It is an effective way to hedge a currency exposure but not an effective way to trade speculatively.

Broadly speaking there are three main reasons for entering into a currency swap:

1. To hedge a long-term borrowing commitment in a foreign currency.

   In order to expand into foreign markets, companies will often try to hedge any foreign exchange exposures naturally. However, this is not always possible. For example, a company may raise funds to build a production plant in Poland. In order to pay the cost of building the plant in zlotys, it raises the original capital in zlotys. However, the output from that plant is sold all over Europe and only a small proportion of the receipts are denominated in zlotys. The company may decide to swap its borrowing from zlotys into say euros so that it can meet its repayment requirements using the revenue streams provided from the sale of the plant’s output.

2. To access cheaper capital markets.

   Unlike 1., it may also be cheaper to access a capital market for funds even though the company may not have a requirement for funding in that currency. For example, there are often circumstances in which multinational companies can raise funds most efficiently in the US capital markets, even when the funding requirement has arisen from a project in Europe. There can be a number of reasons for this ranging from lower market rates through to the fact that a US entity may enjoy a better credit rating than its European subsidiary. However this may arise, a company may decide to raise funds in one currency before swapping it into another. The cost of the currency swap and any residual foreign exchange risk should be considered as part of the cost of tapping a foreign capital market. The point is that the overall cost will be lower than if the company raised funds in the swapped currency.

3. To bypass remaining exchange controls.

   Where exchange controls do remain, currency swaps are a useful tool to enable funds to be raised without breaching the currency restrictions that are in place.

Types of currency swaps

There are three main types of currency swaps:

1. Fixed/fixed.

   A fixed/fixed currency swap involves the exchange of fixed cash flows in one currency for fixed cash flows in another currency.

2. Fixed/floating.

   A fixed/floating currency swap, also known as a cross-currency swap, results in the exchange of fixed cash flows in one currency for cash flows based on a floating interest rate in another currency.

3. Floating/floating.

   A floating/floating currency swap, referred to as a currency basis swap, exchanges cash flows in two currencies, where both sets of cash flows are determined by variable interest rates.

It is important that the type of currency swap employed fits with the overall debt management policy of the company.

How do they work?

Currency swaps are available for any period of time between six months and twenty-five years. However, the associated currency risk means that most swaps are under seven years in duration.

Although there is usually an exchange of principal, the company is still legally responsible for making the interest payments to its lenders in the US. Any company entering into a currency swap agreement needs to be aware of the counter-party risk involved (the risk, in this case, that the counter-party will default on the swap agreement). If the counter-party did default, then the company would still have to meet the USD interest payments.

What do they cost?

Except for an initial exchange of principal, there is no initial fee or premium when arranging a currency swap.

The cost of a swap depends on two key variables:

1. The rate at which the principal will be exchanged.

   Where there is an initial exchange of principal, this will determine the exchange at maturity. Where there is no initial exchange of principal, the rate should be fixed when arranging the swap. This rate is usually the prevailing spot rate.

2. The interest rates for the swaps will include a profit margin.

   This will include whether the rates will be fixed or floating. If the rate is floating, then this will include the reference rate.

Although one party is likely to make a loss on the foreign exchange transaction, the agreement should be structured so that both parties can gain from it. In our example above, the company will want to ensure that the sterling repayments as a result of the swap agreement are lower than those repayments would have been if the company borrowed in sterling (rather than USD). The bank will benefit because it will be able to access the sterling funding at a lower rate than the company and will include a profit margin in the interest rate it receives. In addition, the bank will be able to lend out the USD at a higher rate of interest than it has to make the repayments.

Legal issues

Before a company can agree a swap with a counter-party bank for the first time, it will need to sign documentation making the agreement legally binding. Such an agreement will usually be based on the ISDA (International Swaps and Derivatives Association) master agreements. These are standardised and are now used by most of the international banks. This makes it easier for companies to negotiate legal agreements with a range of counter-party banks. However, the detail of each agreement needs to be negotiated between the company and every counter-party bank, which can take some time.

Advantages of a currency swap

The main advantage of currency swaps is that they open up alternatives to a company needing to raise finance. They can be arranged for any period of time and for a wide range of currencies. Once a legal agreement is in place with a counter-party bank, individual currency swaps can be agreed at very short notice.

Currency swaps mean that companies are not forced to raise initial capital in the currency in which they have a requirement. There are two common benefits that arise:

• Firstly, the company can raise funds in their domestic market, where their name recognition may allow them a beneficial rate, and then swap into the currency in which they have a requirement. This is particularly useful when a company is moving into a new market.

• Secondly, it allows a company to take advantage of lower interest rates and to access the more liquid capital markets. European companies have typically used currency swaps to take advantage of the deeper markets in the US.

Currency swaps do not have to be arranged with the same bank that provided the original financing. However, for smaller companies, the relationship bank may be the only body prepared to provide the necessary credit lines.

Finally, depending on how they are structured, currency swaps will provide a degree of certainty for the company. As with interest rate swaps, currency swaps allow the company to arrange to make interest payments on either a fixed or floating basis.

Disadvantages of a currency swap

Despite these advantages, there are a number of points that should be considered prior to arranging a swap:

• A legal agreement needs to be in place before the swap is agreed.

• The credit of your counterparty bank needs to be considered.

  The risk taken is equal to the replacement cost of the absent interest rate stream.

• Position risk.

  It is important to remember that a currency swap can be used to help manage interest rate exposure as well, usually via a cross-currency swap agreement. You should also consider the interest rate that you agree, particularly if you are fixing the rate. Bear in mind that a fixed interest rate may seem less attractive if the interest rate changes.

• Currency swaps are less liquid than interest rate swaps.

  This is particularly true for less common currency pairs. This makes it more difficult to reverse an agreement if the underlying conditions change.

• When a company wants to make a currency swap for a less common currency pair.

  This sometimes has to be arranged as two swaps. The first currency would be swapped into a reference currency (typically USD) and then into the second currency. In these cases, a third party may be required if the original currency pair is particularly unusual. In these circumstances, it is important to note the nature of all the counter-parties involved in the transaction.

Used correctly, a currency swap is a useful and flexible tool for the treasurer.