Currency Swap

Organizations both profit and non profit really need finance for lots of things, expansion, growth, consolidation, payment of dividends, and many more reasons. At times, these funds may not be sitting idle in some bank vaults on their behalf, but has to be borrowed. While there are source of funds, both short and long term, firms are always on the market for cheaper source of funds. Apart from the low interest a cheaper fund attracts, firms can also use it for significantly long time, without feeling the pinch. For firms in the market for foreign currency for investment purposes abroad or any other reason, a currency swap is usually a good source of cheaper funds.

Currency swap which is one of the basic financial derivatives instruments involves privately negotiations between 2 parties to swap a specified payment obligations denominated in one currency for payment obligation denominated in another currency. For instance, swapping USD (US Dollar) for Euros.

Currency swap came about because of foreign exchange restrictions introduced by countries on the amount and cost of obtaining foreign currency. Currency swap is a very good method of bypassing these restrictions. Its main advantage is the provision of a cheaper source of funds for the companies concerned. For instance it will be easier for a US based corporation to raise USD than for a Europe based corporation; likewise, it will be easier for a Europe based corporation to get hold of Euros than a US based one. It also bypasses restrictions imposed by governments on foreign currency.

Currency swaps can be plain vanilla currency swap or interest rate swap. Plain vanilla currency swap involves the exchange of principal and interest in one currency for principal and interest in another currency. The principal sums exchanged in the two currencies are equal to each other.

Currency swaps may involve initial set up costs such as agent fees and cost of finding and linking interested parties which may be high. Since swaps are Over-the-counter (OTC) agreement and privately negotiated, it carries with it risk of default. This cannot be compared with exchange traded instruments which are relatively safer. However, it left to the companies involved to fully analyze the cost and other related expenses to justify the use of currency swap to raise foreign exchange. If the cost is not justified, then, another source should be considered.