Distinction between FX swaps and currency swaps for FX risk management
Updated: Mar 22, 2022
It is fairly common to see some investors assume that FX swaps and Currency swaps are the same and will often use these terms interchangeably. While both of them are derivative instruments used for hedging foreign currency exposures, each of them has distinct features which differentiate them and make them suitable for different purposes depending on the investment horizon/ risk profile of the investor.
In addition to being derivative instruments used for hedging, some of the similarities of FX swaps and Currency swaps include;
FX swaps and Currency swaps involve the exchange of two different currencies at inception and reversal of the same currencies at the end of the contract.
Both instruments are agreements that require no initial outlay as they both have an initial market value of zero.
Both of them are exposed to counterparty risks as they are OTC instruments that are privately negotiated and thus lack the type of transparency that futures command as they are not usually entered into, on an organized exchange.
Let’s separately look at some of the features and possible applications of both instruments.
FX SWAPS
FX swaps, just like Currency swaps, are derivative instruments used to hedge against adverse movements in foreign currency positions. However, FX swaps differ from currency swaps in the manner that the currencies are exchanged. FX swaps usually have two legs; the first leg which is the ‘near leg’ involves buying/selling of one currency against another currency at a spot rate while the second leg(‘the far leg’) involves reversing the exchange direction of both currencies at the end of the swap using a forward rate. Both legs are akin to lending one currency and simultaneously borrowing another currency at the start of the agreement and reversing the transactions at the end.
It is commonplace to use FX swaps to mitigate currency fluctuation in the short term. In addition, they serve two major purposes;
To rollover forward contracts upon expiration if the investor intends to maintain a hedged position.
To modify sizes of forward contract positions if the value of the hedged exposure is expected to increase or decrease.
The following illustration will help for a practical understanding;
A hypothetical exporter based in Nigeria, Sweet Tubers Nig plc exports yams to the USA and is expecting export proceeds of one million dollars from a US importer in 6 months’ time. Sweet Tubers decides to enter into a forward contract to hedge against potential adverse currency movement against the dollar. This is achieved by selling forward 1 million dollars and buying forward the naira equivalent at an agreed forward rate. This simply means taking delivery of one million dollars at expiration while paying an equivalent naira value determined by the forward rate. When the date of settlement approaches, Sweet Tubers may wish to employ FX swaps for two reasons;
To roll over the forward contract at expiration if the date of settlement of the export proceeds of 1 million dollars has been extended by the US importer.
To modify the forward contract size if the export proceeds of one million dollars are expected to increase or decrease.
To explain the first point above, if the date of settlement of the export proceeds has been extended by three months, Sweet Tubers can employ a ‘matched’ FX swap to roll over the forward contract on the date of expiration. This will entail buying 1 million dollars at expiration at the previously agreed forward rate to close out the contract, and immediately entering into a fresh agreement to sell one million dollars forward to be delivered in 3 months’ time at a new forward rate(swap rate). This effectively maintains the hedged position.
To explain the second point, when the expiration date of the forward contract approaches and Sweet Tubers discovers that, in addition to the 3 months extension of the date of settlement of the export proceeds, the expected value of the export proceeds has changed from 1 million to 1.5 million dollars, it can employ a ‘mismatched’ FX swap to modify the contract size by closing out the forward contract of 1 million dollars upon expiration. This will be achieved by buying the 1 million dollars at the earlier agreed forward rate and simultaneously selling a 1.5 million dollar forward contract to be delivered in 3 months’ time. This serves the dual purpose of maintaining the hedged position and modifying the contract size to hedge the expected dollar proceeds.
CURRENCY SWAPS
These are derivative instruments frequently used in the medium to long term by international investors, banks, multilateral corporations, institutional investors, etc., to hedge against adverse currency movement and to effectively minimize borrowing costs.
It entails the exchange of notional principals of two different currencies by two parties at the start and at the end of the agreement while paying/receiving interim cash flows in-between either at a floating or fixed rate. E.g. At the start of the contract, Party X pays 300 million naira to Party Y while Party Y pays 1 million dollars to party X. At the end of the contract, Party Y returns 300 million naira to Party X while Party X returns I million dollars to Party Y.
As alluded to above, a distinct feature of currency swaps is the payments made in-between by both parties on the currency each party received at the start of the agreement. E.g. Party X pays 3% on 1 million dollars periodically to Party Y while Party Y pays 10% of 300 million naira periodically to Party X.
The periodic payments could be floating or fixed. If any of the parties agree to pay at a fixed rate then this will be determined at the beginning of the contract period using domestic interest rates such as LIBOR in London or the equivalent in other countries. The process of determining the fixed rate is called pricing.
Parties that engage in currency swaps are generally of good credit quality.
The following example will help for an intuitive understanding;
Blue tops plc. , a bank in Nigeria intends to start operations in South Africa and needs 500 million SA Rands to fund this expansion. Blue tops is not known in South Africa and will therefore attract relatively high lending rates to compensate for credit risk should it decide to take a loan. Similarly, investors will demand a high-interest rate should Blue tops attempt to issue bonds in South Africa. However, an international swap dealer based in South Africa such as Gold line bank who is familiar with Blue tops can enter into a 5-year swap deal whereby at initiation Gold line bank pays the required 500 million Rands at 5% to Blue tops and receives 13 billion naira in return at 6 %. Also, semiannual payments are made on the notional principals. Blue tops may decide to issue bonds worth 13 billion Naira in Nigeria at a low-interest rate to finance the swap deal.
From Blue tops's perspective, this swap deal effectively replicates the issuance of bonds in Nigeria with a 5-year tenor and converting it into the issuance of bonds in South Africa at 5%. It would have been much more expensive to borrow from lenders or to issue bonds directly in South Africa.
The following are examples of International Investors and organizations that regularly use currency swaps.
Multilateral institutions such as IMF, World Bank, etc., lend medium to long-term funds to developing countries and will need to hedge the expected debt repayment. They can decide to enter into currency swaps with swap dealers to make payments in the borrowing countries’ currencies and receiving payment in their domestic currencies e.g. dollars, thereby mitigating exchange rate volatility.
Banks, Institutional Investors, Multinationals, etc., that intend to take loans or issue bonds abroad to fund existing or expanding operations and are seeking to lower their lending rates.
International Investors who buy bonds, equity, real estate, private equity, etc., in foreign countries and who may want to hedge their investments against adverse exchange rate fluctuations.
To reiterate, both FX swaps and Currency swaps are derivative instruments used for hedging against adverse exchange rate fluctuation. However, FX swaps are usually employed for the short term e.g. under 1 year, and are used to rollover forward contracts and/or to modify existing forward contract sizes, while Currency Swaps, on the other hand, are frequently used for medium to long term e.g. 2 years to 15 years and are generally effective for minimizing borrowing costs.
Chibuzo Akubue writes from Lagos, Nigeria