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A Currency Swap involves exchange of principal and/or interest payments on a loan or on an asset in one currency for principal and/or interest payments on an equivalent loan or on an asset in another currency, with a predetermined prevailing spot / predetermined forward rate (for forward start swaps) as agreed on the date the transaction is entered into.
For example, a customer in India with a long term USD borrowing is typically exposed to exchange rate risk between the USD and the Indian Rupee (INR). If the company wishes to eliminate the USD interest rate risk and the USD/INR currency risk it may do so by entering into a USD/INR currency swap with a bank (as per the prevailing regulations).
The customer does the swap with the bank by receiving USD floating interest rate payments and USD principal amortisations. Simultaneously, the customer pays INR fixed interest rate and the equivalent INR principal amortisations at an exchange rate based on the spot rate (or forward rate) prevailing on the transaction date and locked in for the entire tenor of the swap.
The client may be covering only interest payments, only principal repayment at maturity, or interest payments & principal repayments (amortization).
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Client hedges for his interest payments and principal repayments |
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Client hedges for his interest payments only. |
This is not a very widely preferred option from the client point of view as typically exchange rate on the principal is more risky than the exchange rate risk on the interest portion only.
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Client hedges for principal only. |
In this arrangement, bank agrees to deliver on maturity an agreed principal of one currency to the client at the current rate of exchange. In return the client agrees to pay in the other currency, the equivalent amount of the principal on maturity as also a fixed rate of interest on the principal amount at agreed intervals. |
