Although a relatively recent invention, currency swaps have quickly become a vital and widely used financial instrument. Given the steady increase in globalization, understanding the potential benefits of using currency swaps is essential to any modern multinational business. Currency swapping works just as the name implies – different national currencies are swapped between two parties for an agreed amount of time. Investopeia.com defines a currency swap as “two notional principals [of different currencies] that are exchanged at the beginning and at the end of the agreement” (Cavallaro, 2011).
Typically, the reason to engage in a currency swap with another company is because a company may have a comparative advantage in getting a loan in one currency, typically their domestic currency, though they might desire the funds to be in a foreign currency. If they can find a counterpart who also has a comparative advantage in getting financing in their domestic currency, both companies can benefit though a currency swap.
To illustrate this, imagine that a well-know U.S. based corporation wants to expand its operations in Europe. Perhaps it will receive more attractive financing in the U.S. based on its reputation and contacts than in Europe; so the company can get a loan from a U.S. bank at a relatively low rate and then simply swap the dollars for Euros with a European company which needs USD and likewise has an advantage in financing options in its domestic currency (McCaffrey, 2007). Another reason a currency swap might be beneficial to a company is to hedge against currency fluctuations. Consider a U.S. firm that is seeking to hedge some of its euro exposure by borrowing in euros; by arranging a currency swap with a European company that is seeking dollars, the U.S. firm can hedge its risk against currency fluctuations in the euro (Shapiro, 2006, p. 317).
While the concept of currency swaps may be straightforward enough, and the advantages of currency swapping obvious, the actual mechanisms by which a currency swap is put into place can be extremely complex. Moreover, there are several variations of currency swaps - each with different advantages and disadvantages for certain companies depending on the company’s preferences and risk tolerance.
One of the common variations of currency swaps allows for a company not only to take advantage of any comparative advantages in lending, but to exchange a fixed-rate loan for a floating-rate loan or vice versa. To understand how switching a floating rate loan for a fixed rate loan can be accomplished, we will need to look in detail at a theoretical currency swap between two companies. Let us suppose that a U.S. based company, Acme Corp, wants $200 million dollars worth of Euros in order to expand its operations in France. With the assistance of a bank that specializes in currency swaps, a European company, Le Compagnon, is found which is seeking dollars in order to hedge themselves against currency...