Introduction

Currency swaps are vital tools in international finance, enabling entities to manage foreign exchange risk and optimize their funding costs. A currency swap involves an agreement between two parties to exchange principal and interest payments denominated in different currencies over a specified period. This chapter delves into the mechanics of currency swaps, elucidating the process by which these instruments operate and examining the calculation of cash flows in currency swap transactions.

Currency Swaps

A currency swap typically consists of two distinct legs: the principal exchange and the interest rate exchange. In the principal exchange, two parties agree to exchange notional amounts of different currencies at the outset and then again at the end of the swap term. This process allows each party to acquire the desired currency without incurring exposure to fluctuating exchange rates.

The interest rate exchange, on the other hand, involves the exchange of periodic interest payments. Each party pays interest in the currency they borrow, calculated based on an agreed-upon interest rate (often a floating rate like LIBOR) and the notional amount. The counterparties then exchange these interest payments, effectively allowing one party to borrow in its preferred currency at a rate that would otherwise be inaccessible due to foreign credit restrictions or higher costs.

Computation of Cash Flows in Currency Swaps

The calculation of cash flows in currency swaps involves determining the interest payments and principal exchanges at each payment date. Let’s consider a simplified example:

Example: Suppose Company A, based in the US, and Company B, based in the UK, enter into a currency swap. Company A agrees to pay Company B fixed-rate interest in British pounds (GBP), while Company B pays Company A variable-rate interest in US dollars (USD). The notional amount of the swap is $5 million and £3 million, respectively. The swap term is two years, with semiannual payments.

Company A’s fixed interest rate: 4.5% per annum
Company B’s variable interest rate: 3-month GBP LIBOR + 1.5%

At each payment date, the parties calculate and exchange interest payments based on the notional amounts and agreed-upon rates. The periodic cash flows are determined as follows:

Year 1, Payment 1 (USD to GBP):

• Company A pays: $\text{USD 5 million} \times \frac{4.5\%}{2} = 112,500$
• Company B pays: $\text{GBP 3 million} \times \frac{\text{(3-month GBP LIBOR + 1.5%)}}{2}$

Year 1, Payment 2 (GBP to USD):

• Company A receives: $\text{USD 5 million} \times \frac{\text{(3-month GBP LIBOR + 1.5%)}}{2}$
• Company B receives: $\text{GBP 3 million} \times \frac{4.5\%}{2} = GBP 67,500$

This exchange of payments continues over the remaining periods of the swap, with each party making payments in their respective currencies and receiving payments in the other currency based on the agreed-upon terms.