Currency swaps follow a simple principle: You scratch my back, and I scratch yours. However, this simple logic can be turned into a more advanced form: You scratch my neighbour’s back while I scratch your neighbour’s back. There can be no end to financial innovations leading to different kinds of currency swaps. But, today, our friend Johnny is trying to understand the simplest kind of currency swaps.
Illustration: Jayachandran/ Mint
Johnny: Hi, Jinny! I really enjoyed your “swap song” last week. Now, tell me how currency swaps work.
Jinny: Currency swaps could be of different kinds, but all of them essentially serve the same purpose—they can be used for converting a loan or investment in one currency into another currency.
If you have made investments denominated in US dollars but now want to convert it into an investment denominated in Indian rupees, you can use currency swaps. Likewise, if you have taken a loan in Indian rupees but actually want a loan in Japanese yen, you can use currency swaps.
Johnny: Could you give me an example?
Jinny: I will tell you about fixed-to-fixed currency swaps, one of the simplest currency swaps. It involves agreement for exchanging principal and fixed interest payments in one currency for principal and fixed interest payments in another currency. In other kinds of currency swaps, exchange of the principal amount is followed by exchange of the fixed interest rate with a floating interest rate or one floating interest rate with another floating interest rate.
Let us try to understand how currency swaps can be used for converting a loan in one currency into another. Suppose X is an American firm that requires a loan in Indian rupees for starting a business in India and Y is an Indian firm that requires a loan in US dollars. Suppose firm X raises a loan of $1 million (around Rs4 crore) at an interest rate of 6% per annum, whereas firm Y raises a loan of Rs4 crore at a rate of 8% per annum. But both the firms have opposite needs. Firm X actually requires a loan in Indian rupees, while firm Y requires a loan in US dollars. What can these firms do?
Johnny: I think both of them can sing a swap song.
Jinny: Both firms can decide to swap their loans. At the beginning of their swap agreement, both firms exchange the principal amount of their loan. The exchange of the principal amount is done at the prevailing exchange rate or at a rate fixed under the swap contract.
As you are aware, in the interest rate swap, the principal amount is swapped only on a notional basis whereas in a currency swap, actual exchange of principal amounts takes place.
Firm X receives Rs4 crore from firm Y in exchange for $1 million. But that is not all. The payment of 6% interest on the loan in dollars would now be done by firm Y and the payment of 8% interest on the loan in rupees would be done by firm X.
At the end of the swap agreement, both the parties would again exchange the principal amounts of the loan with each other, either at the then prevailing exchange rate or at a rate fixed under the swap agreement or at the rate at which the initial exchange was made. Both firms can fix the terms of the agreement as per their requirement. This is how two parties scratch each other’s back in what we call currency swaps.
Johnny: But how does scratching each other’s back really help? I mean, why don’t the firms directly raise the loan in the desired currency? What extra benefits do both the firms enjoy by entering into a swap deal?
Jinny: Currency swaps work on the principle of comparative advantage. It helps both the firms. Firm X, an American firm, may be enjoying a comparative advantage over firm Y, an Indian firm, in raising loans denominated in US dollars. Due to its presence in the US markets, firm X may have a better credit rating than firm Y and so it could raise a loan at 6% interest rate whereas if firm Y had gone directly to the US market, it could perhaps have got the same loan only at a much higher interest rate. But, in India, the situation may be just the opposite. Here, firm Y may enjoy a comparative advantage over firm X and hence it could take a loan on a much lower interest rate than firm X. So, both firms take the loan from markets where they enjoy a comparative advantage and later swap it. The effect of the swap is that both the firms manage to convert their loans into the currency of their choice at a much lower interest rate than they might have paid if they had taken the loan directly.
Johnny: It is always good to find someone who thinks that scratching each other’s back is more profitable than scratching one’s own back.
What:Currency swaps can be used for converting a loan or investment in one currency into another currency.
When: The principal amount is swapped at the beginning and end of the contract. The interest payments are swapped on several dates as per the terms of the contract.
How: Currency swaps work on the principle of comparative advantage—both parties are better off by entering into a swap deal.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at email@example.com