Introduction

Currency swaps are powerful financial instruments that enable entities to manage their foreign exchange exposure while also facilitating the transformation of assets and liabilities denominated in different currencies. In this chapter, we will delve into how currency swaps can be employed to effectively convert one currency’s financial obligation into another, thus achieving desired asset/liability management objectives. We will explore the mechanics of this process and provide calculations of resulting cash flows through illustrative examples.

Understanding Asset or Liability Transformation

Currency swaps offer a unique avenue for transforming assets and liabilities across different currencies, allowing entities to align their financial obligations with their strategic goals. The transformation process involves exchanging cash flows in one currency for cash flows in another currency over a predefined period, typically referred to as the swap’s tenure.

Calculating Resulting Cash Flows

The cash flows resulting from a currency swap involve periodic payments in two different currencies, each based on a predetermined notional amount. The notional amount remains constant throughout the swap’s tenure and serves as the basis for calculating the payments. The cash flows can be split into fixed and floating components, much like interest rate swaps.

• Formula for Fixed Payments: The fixed payments can be calculated using the following formula:

$$ \text{Fixed Payment = Notional Amount} \times \text{Fixed Rate}$$

Example: Let us consider a Company A (based in the United States) which has a USD 10 million liability denominated in Euros, and Company B (based in the Eurozone) which has a 7 million euros liability denominated in USD. Both companies can enter into a currency swap to transform their liabilities. Company A will make fixed-dollar payments to Company B, while Company B will make fixed-euro payments to Company A.

Let’s assume the fixed rate for the swap is 4% and the exchange rate is 1 Euro = 1.20 USD. The notional amount for both companies is USD 10 million and 7 million euros, respectively.

• Company A’s fixed payment = $\text{USD 10,000,000} \times 0.04= \text{USD 400,000}$
• Company B’s fixed payment = $\text{7,000,000 euros} \times 0.04 = \text{280,000 euros}$

Conversely, the floating payments are determined by referencing a floating rate index (e.g., LIBOR) and applying a spread. These payments fluctuate with market interest rates.