Currency Swap vs. Interest Rate Swap: An Overview
Swaps are derivative contracts between two parties that involve the exchange of cash flows. One counterparty agrees to receive one set of cash flows while paying another set of cash flows to the other. Interest rate swaps involve the exchange of interest payments, while currency swaps involve the exchange of a cash amount in one currency for the same amount in another.
Key points to remember
- Swaps are derivative contracts in which one counterparty agrees to exchange cash flows with another.
- Interest rate swaps involve the exchange of cash flows generated by two different interest rates, for example, fixed or variable.
- Currency swaps involve exchanging cash flows generated by two different currencies to hedge against exchange rate fluctuations.
Interest rate swaps
An interest rate swap is a financial derivative contract in which two parties agree to exchange their interest rate cash flows. Interest rate swap usually involves swapping between predetermined notional amounts with fixed and floating rates.
For example, suppose Bank ABC has a $10 million investment, which pays the London Interbank Offered Rate (LIBOR) plus 3% each month. Therefore, this is considered a floating payment because as LIBOR fluctuates, the cash flow also fluctuates.
On the other hand, suppose bank DEF has a $10 million investment that pays a fixed rate of 5% each month. Bank ABC decides that it prefers to receive a constant monthly payment while bank DEF decides to take a chance on receiving higher payments. Therefore, the two banks agree to enter into an interest rate swap contract. ABC Bank agrees to pay DEF Bank LIBOR plus 3% per month on the notional amount of $10 million. DEF Bank agrees to pay ABC Bank a fixed monthly rate of 5% on the notional amount of $10 million.
As another example, suppose Paul prefers a fixed rate loan and has variable rate (LIBOR + 0.5%) or fixed rate (10.75%) loans. Mary prefers a variable rate loan and offers variable rate (LIBOR+0.25%) or fixed rate (10%) loans. Due to a better credit rating, Mary has an advantage over Paul in both the floating rate market (by 0.25%) and the fixed rate market (by 0.75%). Its advantage is greater in the fixed rate market, so it takes out the fixed rate loan. However, since she prefers the variable rate, she enters into a swap agreement with a bank to pay the LIBOR and receive a fixed rate of 10%.
Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives LIBOR from the bank. His net payout is 10.6% (fixed). The swap effectively converted his initial floating payment to a fixed rate, getting him the most economical rate. Similarly, Mary pays 10% to the lender and LIBOR to the bank and receives 10% from the bank. Its net payout is LIBOR (floating). The swap effectively converted his initial fixed payment to the desired float, getting him the most economical rate. The bank takes a 0.10% share of what it receives from Paul and pays it to Mary.
Conversely, currency swaps are a foreign exchange agreement between two parties to exchange cash flows in one currency for another. While currency swaps involve two currencies, interest rate swaps only deal with one currency.
For example, suppose bank XYZ operates in the United States and deals only with US dollars, while bank QRS operates in Russia and deals only with rubles. Suppose QRS Bank has investments in the United States worth $5 million. Suppose both banks agree to enter into a currency exchange. Bank XYZ agrees to pay Bank DEF LIBOR plus 1% per month on the notional amount of $5 million. QRS Bank agrees to pay ABC Bank a fixed monthly rate of 5% on the notional amount of 253,697,500 Russian Rubles, assuming that 1 USD equals 50.74 Rubles.
By agreeing to a trade, the two companies were able to obtain low-cost loans and hedge against interest rate fluctuations. Variations also exist in currency swaps, including fixed vs. floating and floating vs. floating. In sum, parties are able to hedge against exchange rate volatility, obtain improved lending rates and receive foreign capital.