How to Hedge Currency
Swap currencies and interest rates with a party in a currency swap., Exchange interest payments in a currency swap, not principals., Calculate your interest rate payment., Work with a partnering financial institution to mediate the swap., Use...
Step-by-Step Guide
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Step 1: Swap currencies and interest rates with a party in a currency swap.
In a such a swap, two parties agree to swap equivalent amounts of cash (called principal) as well as interest rate payments over a fixed period of time.
The cash usually originates as debt (a party issues a bond) or as credit (a party gets a loan).
The principals exchanged are usually equivalent amounts:
Party A swaps $1,000,000 for €750,000 from Party B, based on the exchange rate.
The swapped interest rate payments, however, are usually not the same.
Here's a very basic example.
Vitaly Partners, an Italian company, wants to hedge against the euro by buying dollars.
Vitaly agrees on a currency swap with Brand USA, an American company.
Over five years, Vitaly sends Brand USA €1,000,000 in exchange for the dollar equivalent, about $1,400,000.
Vitaly agrees to swap interest payments with Brand USA as well:
Vitaly will pay Brand USA 6% interest on its swapped principal, €1,000,000, while Brand USA will pay Vitaly
4.5% interest on its swapped principal, $1,400,000. -
Step 2: Exchange interest payments in a currency swap
The principal that the two parties agree to swap isn't actually exchanged.
It is kept by both parties.
The principal is what financiers call a notional principal, or an amount that is theoretically exchanged but actually kept.
Why is the principal needed, then? It's needed to calculate the interest payments, which are the backbone of any currency swap. , Interest rate payments are usually swapped at six-month or one-year intervals, and this is where the parties transfer currencies that help them hedge against fluctuations in their own currency.
Let's look at an example:
Vitaly agreed to swap €1,000,000 at 6% to Brand USA in exchange for $1,400,000 at
4.5%.
Let's assume that interest rate payments are swapped every six months.
Vitaly's interest rate payment will be calculated as follows:
Notional principal x interest rate x frequency.
Every six months, Vitaly will pay Brand USA €30,000, in euros. (€1,000,000 x .06 x .5 = €30,000.) Brand USA's interest rate payment will be calculated as follows: $1,400,000 x .045 x .5 = $31,500.
Brand USA will pay Vitaly $31,500, in dollars, every six months. , For simplicity, this example so far has avoided a third party that's involved in the swap — banks.
When Vitaly sends its interest payments over to Brand USA, it does so by sending the bank the interest payment first; the bank takes a small cut and sends the rest of the interest payment on over to Brand USA.
Ditto for Brand USA: it must also mediate the transaction through the bank, which takes a small cut from their swap for granting the privilege. , Why choose currency swaps instead of just buying foreign currency? Currency swaps involve two parties.
Remember Vitaly and Brand USA.
Vitaly gets a better interest rate on its loan of €1,000,000 in Italy than it would if it asked for the loan in America.
Likewise, Brand USA gets a better interest rate on its $1,400,000 loan in America than it would if it got the loan in Italy.
By agreeing to exchange interest rate payments, currency swaps bring together two parties that each have better loan agreements in their own countries and their own currencies. -
Step 3: not principals.
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Step 4: Calculate your interest rate payment.
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Step 5: Work with a partnering financial institution to mediate the swap.
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Step 6: Use currency swaps if you get better loan rates at home than you do abroad.
Detailed Guide
In a such a swap, two parties agree to swap equivalent amounts of cash (called principal) as well as interest rate payments over a fixed period of time.
The cash usually originates as debt (a party issues a bond) or as credit (a party gets a loan).
The principals exchanged are usually equivalent amounts:
Party A swaps $1,000,000 for €750,000 from Party B, based on the exchange rate.
The swapped interest rate payments, however, are usually not the same.
Here's a very basic example.
Vitaly Partners, an Italian company, wants to hedge against the euro by buying dollars.
Vitaly agrees on a currency swap with Brand USA, an American company.
Over five years, Vitaly sends Brand USA €1,000,000 in exchange for the dollar equivalent, about $1,400,000.
Vitaly agrees to swap interest payments with Brand USA as well:
Vitaly will pay Brand USA 6% interest on its swapped principal, €1,000,000, while Brand USA will pay Vitaly
4.5% interest on its swapped principal, $1,400,000.
The principal that the two parties agree to swap isn't actually exchanged.
It is kept by both parties.
The principal is what financiers call a notional principal, or an amount that is theoretically exchanged but actually kept.
Why is the principal needed, then? It's needed to calculate the interest payments, which are the backbone of any currency swap. , Interest rate payments are usually swapped at six-month or one-year intervals, and this is where the parties transfer currencies that help them hedge against fluctuations in their own currency.
Let's look at an example:
Vitaly agreed to swap €1,000,000 at 6% to Brand USA in exchange for $1,400,000 at
4.5%.
Let's assume that interest rate payments are swapped every six months.
Vitaly's interest rate payment will be calculated as follows:
Notional principal x interest rate x frequency.
Every six months, Vitaly will pay Brand USA €30,000, in euros. (€1,000,000 x .06 x .5 = €30,000.) Brand USA's interest rate payment will be calculated as follows: $1,400,000 x .045 x .5 = $31,500.
Brand USA will pay Vitaly $31,500, in dollars, every six months. , For simplicity, this example so far has avoided a third party that's involved in the swap — banks.
When Vitaly sends its interest payments over to Brand USA, it does so by sending the bank the interest payment first; the bank takes a small cut and sends the rest of the interest payment on over to Brand USA.
Ditto for Brand USA: it must also mediate the transaction through the bank, which takes a small cut from their swap for granting the privilege. , Why choose currency swaps instead of just buying foreign currency? Currency swaps involve two parties.
Remember Vitaly and Brand USA.
Vitaly gets a better interest rate on its loan of €1,000,000 in Italy than it would if it asked for the loan in America.
Likewise, Brand USA gets a better interest rate on its $1,400,000 loan in America than it would if it got the loan in Italy.
By agreeing to exchange interest rate payments, currency swaps bring together two parties that each have better loan agreements in their own countries and their own currencies.
About the Author
Kayla Hughes
A passionate writer with expertise in lifestyle topics. Loves sharing practical knowledge.
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