What is Currency Hedging?

How Currency Swaps Work

One of the most popular currency hedging tools is a "currency swap." It is a financial instrument that involves the exchange of interest in one currency for the same in another currency.

Currency swaps comprise two payments exchanged at the beginning and end of the agreement. These payments are determined as a principal amount plus interest rate payments. However, a principal amount never gets paid. It's strictly theoretical. Principals are only used as a basis on which to calculate the interest rate payments in currency swaps.

Examples and calculation of currency swaps

If we consider two companies from different countries, their payments and swaps may be in different forms.

A US company is looking to open a €5 million plant in Spain, where its borrowing costs are higher in Europe than at home. Assuming a 1.2 EUR/USD exchange rate, the company can borrow €5 million at 4% in Europe or $6 million at 2% in the US. The company borrows the $6 million at 2% and then enters a swap to convert the dollar loan into euros. A company from Spain, the counterparty of the swap a Spanish company that requires $6 million. Likewise, the Spanish company will be able to attain a cheaper borrowing rate domestically than abroad. Let's assume that it can borrow at 1.5% from banks within the country's borders. At the outset of the contract, the Spanish company gives the US company the €5 million needed to fund the project, and in exchange, the US company provides them with $6 million. Subsequently, these two companies will swap payments every six months for the next two years (the length of the contract). The Spanish firm pays the US company the sum that's the result of $6 million (the notional amount paid by the US company to the Spanish firm at initiation), multiplied by 2% (the agreed-upon fixed rate), over a period expressed as 0.5 (180 days ÷ 360 days). This payment would amount to $60 000 ($6 million x 2% x 0.5). The US company pays the result of €5 million (the notional amount paid by the Spanish company to the US company at initiation), multiplied by 1.5% (the agreed-upon fixed rate), and 0.5 (180 days ÷ 360 days). This payment would amount to €37 500 (€5 million x 1.5% x 0.5).The two parties would exchange these fixed two amounts every six months. Finally, two years after the initiation of the contract, these two parties would exchange the notional principal amounts. Accordingly, the US company would "pay" the Spanish company €5 million, and the Spanish company would "pay" the US аcompany $6 million.

The US company pays a fixed rate. The Spanish company pays a floating rate on another currency (based on a predetermined benchmark rate, such as LIBOR or the Fed Funds Rate).These modifications to currency swap agreements are usually based on the demands of the individual parties, types of funding requirements, and optimal loan possibilities available to companies.

Both companies use a floating rate based on a benchmark rate.

Back

2023-05-25 • Updated

Frequently asked questions

How to start trading?

If you are 18+ years old, you can join FBS and begin your FX journey. To trade, you need a brokerage account and sufficient knowledge on how assets behave in the financial markets. Start with studying the basics with our free educational materials and creating an FBS account. You may want to test the environment with virtual money with a Demo account. Once you are ready, enter the real market and trade to succeed.
How to open an FBS account?

Click the 'Open account' button on our website and proceed to the Trader Area. Before you can start trading, pass a profile verification. Confirm your email and phone number, get your ID verified. This procedure guarantees the safety of your funds and identity. Once you are done with all the checks, go to the preferred trading platform, and start trading.
How to withdraw the money you earned with FBS?

The procedure is very straightforward. Go to the Withdrawal page on the website or the Finances section of the FBS Trader Area and access Withdrawal. You can get the earned money via the same payment system that you used for depositing. In case you funded the account via various methods, withdraw your profit via the same methods in the ratio according to the deposited sums.