Currency risk refers to the possibility of losses from exchange rate fluctuations. Businesses that operate internationally are particularly vulnerable to currency risk, as they may need to convert their earnings from one currency to another. For example, a company that does business in the European Union may need to convert its profits from Euros to U.S. Dollars to pay its American employees. If the value of the Euro falls relative to the Dollar, the company will suffer a loss.

The currency swap market is used as an FX hedge against the risk of exposure to exchange rate fluctuations. Currency swaps can also be used to ensure receipt of foreign monies and to achieve better lending rates.

Let’s Observe These Key Takeaways before Moving Forward

A company that does business internationally may be at risk for currency fluctuations. This means that the exchange rate may change when they convert foreign money back into their domestic currency. To protect against this, they may employ currency swaps, which are a way to reduce the risk of fluctuations in foreign currency exchange rates by swapping cash flows in the foreign currency with cash flows in the domestic currency at a pre-determined rate.

What makes them such an attractive method? Currency swaps are not required to be legally shown on a company's balance sheet the same way a forward or options contract would. Many ETFs and mutual funds are now FX hedged, allowing investors to invest in foreign assets without worrying about currency risk.

‍All about Currency Swapping

Currency swaps are agreements made between two parties to exchange currency. The terms of the swap are agreed upon by the parties and usually involve exchanging an equal amount of currency. The exchanged currency may differ, and the swap may speculate on currency movements or hedge against currency risk.

Currency swaps are usually between financial institutions or on behalf of a non-financial corporation. According to an article by the Bank for International Settlements (BIS), this type of FX hedging accounts for most transactions in global currency markets, especially during COVID-19.

How Currency Swapping Accomplishes FX Hedging

Since a currency swap is a financial instrument that allows two parties to exchange interest payments in one currency for another, it enables them to exchange certain amounts of two different currencies. 

The two parties involved in the swap will agree to trade principal amounts of a certain currency and will also agree to exchange interest payments based on those principal amounts. However, the principal amount is never actually exchanged between the two parties; it is only used as a way to calculate the interest payments. The interest payments are exchanged between the two parties involved in the swap.

To be more specific, it is usually two financial parties that agree to exchange sequences of cash flows in different currencies. The cash flows are denominated in two currencies and exchanged at fixed or floating rates. The purpose of a currency swap is usually to hedge against currency risk, but it can also be used for speculation.

The Connection between FX Swaps and Exchange Rates

Currency swaps are not quick transactions; they usually last for years depending on the individual agreement. Thus, the spot market's exchange rate between the two currencies in question can change dramatically during the life of the trade. 

This is one of the significant reasons institutions use currency swaps. They can determine exactly how much money they will receive and have to pay back in the future. Suppose they need to borrow money in a particular currency, and they expect that currency to strengthen significantly in the coming years. In that case, a swap will help limit the cost of repaying that borrowed currency.

The Connection between FX Swaps and Cross Currency Swaps

A currency swap can also be called a cross-currency swap. For all practical purposes, the two terms are the same. However, there can be minor variations. A cross-currency swap is the same as a regular one. The slight difference is that the two parties exchange interest payments—not local currencies—on the loans during the swap and the principal amounts at the beginning. FX swaps can also involve interest payments, but not all do.

The parties can pay interest in several ways. Both parties can agree to a fixed or floating interest rate, or one party might end up paying a floating interest rate while the other pays a fixed rate. Aside from the FX hedging risk, this type of swap can help borrowers save on interest rates by hedging against exchange-rate risk. This means they can access lower interest rates.

Samples of Currency Swaps for FX Hedging

Let’s look at these examples to understand FX hedging through currency swaps better. Take note that transactions costs have been removed to simplify the explanation:

• Scenario 1: Party A pays a set amount in one currency, while Party B pays a set amount in another.

The company borrows around $5 million at 7 percent and then enters into a swap to convert the dollar loan into euros. Party B, the swap counterparty, may likely be a German company that requires $5 million in U.S. funds. Likewise, the German company will attain a cheaper borrowing rate domestically than abroad—let's say that the Germans can borrow at 6 percent from banks within the country's borders. Under the terms of the swap, 

Party A will make periodic payments to Party B, equal to the difference between the two interest rates, multiplied by the notional principal of 3 million euros. In exchange, Party B will make payments to Party A equal to the same interest rate differential multiplied by the notional principal.

At the outset of the agreement, the German counterpart provided the U.S. company with €3 million. In exchange for €3 million, the U.S. company provides the German company with $5 million.

Thus, according to this contract, the two parties will swap payments every six months for the next three years, which is the agreed-upon length of the contract). The German firm pays their U.S. counterpart the sum that results in $5 million (the notional amount paid by the U.S. company to the German firm at initiation), multiplied by 7 percent (the agreed fixed rate), over a period expressed as .5 (180 days ÷ 360 days). 

On the other hand, This payment would amount to $175,000 ($5 million x 7 percent x .5). The U.S. company pays the Germans the result of €3 million (the notional amount paid by the Germans to the U.S. company at initiation), multiplied by 6 percent (the agreed-upon fixed rate), and .5 (180 days ÷ 360 days). This payment would amount to €90,000 (€3 million x 6 percent x .5).

As mentioned earlier, the two companies would exchange two fixed amounts every six months. Three years after the contract began, they would exchange the notional principals, the stated amount of money each company would pay the other. In this case, the U.S. company would pay the German company €3 million, and the German company would pay the U.S. company $5 million.

• Scenario 2: Party A agrees to pay a certain amount of one currency, while Party B agrees to pay an amount of another currency that fluctuates based on the market.

In this type of interest rate swap, one party (Party A) agrees to make payments to another party (Party B) at a floating interest rate, while Party B agrees to make payments to Party A at a fixed interest rate. The floating rate is based on a predetermined benchmark rate, such as LIBOR or the Fed Funds Rate.

Currency swap agreements are often modified to fit the needs of the individual companies involved. The terms of the agreement may be changed to reflect the different funding requirements and loan options available to the companies.

• Scenario 3: Party A pays a floating rate based on one currency, while Party B pays a floating rate based on another currency.

In this case, the U.S. company (Party A) and the German firm (Party B) make floating rate payments. The payments are based on a benchmark rate. The terms of the agreement, other than the payments, remain the same while maintaining FX hedging.

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FX Hedging through Currency Swaps

If you want to protect your funds from changes in the exchange rate, you can use currency swaps. This involves swapping your funds for one denominated in a different currency. For example, you could swap your U.K. equity fund for a U.S. dollar-denominated fund. This would protect your investment from a decline in the value of the British pound.

Currency-hedged ETFs and mutual funds can help reduce risk exposure for investors. For example, a portfolio manager who has to purchase foreign securities with a high dividend component for an equity fund can hedge against exchange rate volatility by entering into a currency swap. However, this strategy also means that favourable currency movements will not impact the portfolio as beneficial.

The Connection between Currency Swaps and Forward Contracts

A currency forward contract is an agreement to buy or sell a currency at a future date at a predetermined price. These contracts are used to hedge against currency fluctuations or to take advantage of expected changes in exchange rates.

Currency swap forward contracts can help protect companies from losses due to changes in exchange rates. These contracts lock in a certain exchange rate for a set period, allowing companies to budget and plan more accurately. Many funds and ETFs also use forward contracts to hedge against currency risk.

This arrangement is often used in foreign exchange markets to protect against currency fluctuations. For instance, suppose an investor has a portfolio of stocks denominated in British pounds. In that case, they may enter into a forward contract to sell pounds and buy US dollars at a specified exchange rate. This contract protects the value of the portfolio if the value of the pound declines relative to the dollar.

Concerning FX hedging, using a currency swap forward contract comes with a cost, but some investment funds believe that this cost is worth it to reduce their exposure to currency risk. By buying a forward contract, these funds aim to offset any potential losses incurred if exchange rates move against them.

The Connection between Currency Swaps and Mutual Funds

A hedged portfolio has been designed to protect your investment in a sharp decline in a currency’s value. However, this protection is a bit more expensive, as hedged portfolios typically incur more costs than non-hedged portfolios.

Here’s an illustration that will help you understand: Let’s say two mutual funds are made up entirely of Brazilian-based companies. One does not hedge currency risk. The other fund contains the same portfolio of stocks but purchases forward contracts on the real Brazilian currency.

Whether or not to hedge a portfolio against currency risk depends on the investor's prediction of how the real value will change the dollar. If the investor believes that the real will appreciate or stay the same, then it is better not to hedge. However, if the investor believes that the real will depreciate, performing an FX hedge to the portfolio with a currency swap is best.

‍Conclusion

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