FX Swaps Definition
An FX swap is another word for a foreign currency exchange also know as a Forex swap. It is a tool used by two parties or companies to exchange their country's currencies for a set rate, in order to hedge against changes in the floating exchange rate.
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The Basics
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FX swaps work by having two companies agree to borrow money in their country's currency and swap it--along with interest on it--with the other party's currency from his home country. This means that over the course of the swap, the party who owes more interest pays the the swapping party the balance of their interest payments.
Swap Reasons
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The major reason for a swap is to shield a company from the changes in the floating FX market. While the interest payments on a swap are tied to the exchange rate on the date they are made, the principal payment is not. Rather, it is agreed upon beforehand, thus shielding both companies from a major drop in their country's currency values.
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5-Year Swap Agreement
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Assume an American company can borrow $1,000 at a fixed five percent interest rate and a Canadian company can borrow CA$1,000 at a fixed three percent interest rate. Further, assume that the exchange rate in 2010 is one to one. The two companies sign a five-year FX swap agreement.
Tallying the Interest
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At the end of the first year, the exchange rate has not changed, so the Canadian company pays the U.S. company $20 (five percent minus three percent).
Interest Rate Drops
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At the end of 2011, however, the exchange rate has changed. $1 is now worth CA$0.75. So, the Canadian company still owes the U.S. company $20, but it can buy that $20 with CA$15. Its effective interest rate has dropped.
Swap Complete
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Finally, in 2015, the two companies pay each other back, based on the 2010 exchange rate, meaning the Canadian company needs to pay $CD1,000, even though that money is now worth $1,333.33.
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References
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