The Currency SWAP Market: Main Features - Forex Management

The oldest and the most creative sector:
The currency swap market is the oldest and most creative sector of the swap market. This is not distinguished in market terms between the fixed rate currency swap and the currency coupon swap. There is no distinction in market terms between these two types of currency swaps because the only difference is whether the counter currency receipt/payment is on a fixed or floating basis- in structure and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or both counterparties to choose a fixed or floating payment. When the dollar is involved on one side of a given transaction, the possibility to convert a fixed rate preference on one side to a floating rate preference on the other side through interest rate swap market makes any distinction even more irrelevant. However, for those who like fine distinctions, there is a tendency in the market to regard the fixed rate currency swap market as more akin to the long date forward foreign exchange market (because when one is executing a fixed currency swap one may often be competing with the long-date FX market) and the currency coupon swap market as more akin to the dollar bond/ swap market (because the dollar bond issuer compares the below LIBOR spread available in the dollar market to that available, say, through tapping the Swiss Franc market.)

Most Interesting Sector of the Swap Market:
Whatever distinctions one wishes to draw or not to draw between the two basic types of swaps in the currency swap market, there are many reasons why this market is the most creative and therefore, most interesting sector of the swap market. While still smaller than the dollar interest swap market, the currency swap market has great and perhaps even greater potential for growth than the dollar market, particularly in the light of the growth in local/ Euro capital markets in a wide range of currencies.

The Primary and the Secondary Sector:
One can classify activity in the currency swap market into the same two basic sectors as the interest swap market – a primary and secondary sector. In the currency swap market, the primary sector is dominant across the yield curve and the key motivating forces underlying this market are “new money” and “hedging” in that order. “New money” or the willingness to execute swap-related public or private financing in one currency to achieve a finer cost or enhanced availability in another currency is the key motivating force behind the currency swap market, particularly for banks and sovereign entities. Such entities have had large capital and refinancing requirements in recent years. The capacity of any one market (eg: the Eurodollar bond market) to provide all of these requirements at the finest possible cost has been limited. Hence, many banks and sovereign have been willing to approach the private and public debt markets in currencies for which they have no natural requirements (but which the swap market can use) in order to reduce costs and / or gain greater access to a particular currency which is required. Restructuring, or “hedging” current debt portfolios, cash flows or investments, is clearly an influence of second order is comparisons to the influence of “new money”. The flexibility of loan repayment clauses and the fact that many corporate and sovereign entities have found their access to a wide range of securities markets greatly expanded in recent years means that even if the fundamental motivation of a currency swap is restructuring/ hedging, this would normally be preceded by an issuer first obtaining a cheaper cost of funds in the base currency through securities or near security transactions.

The Creativity:
From the market point of view, the driving force of the currency swap market is creativity. Structures in the currency swap market range from the extremely simple to the complex, multi-faceted, multi-counterpart transactions whose economies exist in the dimensions available only to the mathematician. One is limited in the currency swap market only by the problem to be solved, one’s imagination, the skills of your personal computer operators and of course, the ability of your colleagues to find suitable counterparts around the world at the right time and price. As opposed to the dollar market, where capital commitment has become increasingly important, the key in the currency capital commitment has become increasingly important, the key in the currency swap market is still commitment to creative problem-solving and development of a swap distribution system on a global basis—classic investment banking.

Individual Demand and Supply Interplay:
“Warehousing” in the primary market is not widespread due to the difficulty of covering the interest rate risks while the swap is in position. A swap arranger can cover the foreign exchange risks associated with “booking open” a position in a given currency but often times the arranger cannot cover against a movement in interest rates for that currency or is forced to use (generally poor) surrogate cover. This is due to the fact that currency swap rates generally move to the laws of their own supply and demand and do not necessarily relate to say, local government bond markets where cover in some currencies can be obtained (particularly sterling and Deutschmarks). But taking of position does not take place among a few selected players and such market-making is not done on a much wider spread basis versus capital market rates than in the dollar interest swap market. However, until better and more consistent relationship between swap rates and the available interest cover develops, position-taking in the currency swap market will remain very much akin to long-date forward foreign exchange dealing and less toward the classic arbitrage model of the swap market.

The Most Important Currencies of the Swap Market:
The most important currencies in the swap market in rough order of magnitude are the Swiss Franc, Yen, Deutschemarks, Pound sterling and Canadian dollar. These currencies are popular in the swap market due to their low interest rates (versus Dollar) and the relative ease of access by a wide range of issuers to private and public debt in the “Euro” and domestic markets of these currencies. Many supranational and sovereign borrowers find their access to the debt markets of such currencies constrained (versus their sometimes quite large requirements) and therefore make extremely active and frequent use of the currency swap market. Such entities either lend in their currencies (and are therefore covering/ matching assets with liabilities) or are trying to diversify their debt portfolios away from the dollar and the costs of the vagaries of that currency can impose on national budgets.

Dollar’s Domination:
Even after so much development in the swap market, the domination of dollar continues. Though this is also the fact that many direct currency combination continues such as Yen/Swiss Franc. The other high interest rate currencies involved in the currency swap market are viewed as speculative vehicles for aggressive debt portfolio managers or companies in the local market which would have to pay dearly for fixed rate debt. This late comer accounts for the active use of exotic currency debt markets by prestigious international issuers. This has occurred recently in a number of capital markets in which the first few Euro issues are completed at wide divergence to the domestic market rates. Thus, the swaps which become available in this way, have accounted for the presence of many high – powered issues. The quality image gained by such issues, should on these markets has gained acceptance for new market and hence, fostered their growth.
In sum, the primary sector of the currency swap market is dominated by “new money” considerations by issuers and on the other side, by greater access to a select few low interest-rate debt markets by often the same type of entities. There is, however, a greater diversity by type of participants in the currency swap market than the interest swap market with financial institutions, particularly banks, playing a smaller role in the currency market and sovereigns, supranational and corporate playing a relatively larger role than such entities do in the dollar swap market. Position-taking (capital commitment) is still less important than commitment to creativity and distribution capacity among arrangers. While the currency swap market is highly competitive, there is still the possibility to beat your competitor by being smarter, quicker and developing “niches” of special expertise in a particular currency.

Highly Opportunistic Sub-sector:
The secondary market is a highly opportunistic sub-sector of the currency swap market and, judging by Bankers Trust’s own activities in this market, the secondary market in currency swaps is relatively larger in comparison to the primary market. Some of the experts are of the view that this is due to a given swap counterparty having two chances to win on interest and exchange rates- in a currency swap and that with the enormous volatility of the dollar, a chance to win big on an exchange rate play. Although the original motivation may be to create a currency swap but the primary motive in the secondary market is to take profit before a currency move places the swap into an unprofitable position.

New Breed of Financial Management:
The secondary market phenomenon is an inherent part of the new breed of financial management which aggressively manages their cash flows and debt portfolios because they are judged by profits. The spreads tend to be relatively wider in the secondary currency than the secondary interest swap markets, move quickly when an exchange rate breaks is the key to the level of profitability. The exchange rate effects the profitability of a swap reversal is so much that the case of exchange rate that excellent prices and highly attractive rates can be obtained in the secondary market. The reverser needs to move quickly to capitalize on his exchange rate gain. This may lead to the virtual wholesale shutdowns of the primary market in currency swaps. This is so because of the fact that many counterparties want to reverse at the same time. Consequently this will lead to substantial discounts in interest rates on the secondary market versus the primary market.

Position-taking and Market-making:
Unlike in primary market, the position-taking and market-making are very common in the secondary market due to the excellent pricing available in the secondary market, most of the times. Like the dollar market, sophisticated financial managers are aware that the credit risks are greater in currency swaps. When the time comes to reverse a position these sophisticated financial managers will make a market on the original transactions.

The fixed rate currency Swap:

A fixed rate currency swap consists of the exchange between two counterparties of fixed rate interest in one currency in return for fixed rate interest in another currency.

Features of currency swaps

Following are the main features to all currency swaps:

  1. Initial Exchange for the Principal:
    The counterparties exchange the principal amounts on the commencement of the swap at an agreed rate of exchange. Although this rate is usually based on the spot exchange rate, a forward rate set in advance of the swap commencement date can also be used. This initial exchange may be on a notional basis of alternatively a physical exchange. The sole importance of the initial exchange on being either on physical or notional basis, is to establish the quantum of the respective principal amounts for the purpose of –(i) calculating he ongoing payments of interest and (ii) the reexchange of principal amounts under the swap.
  2. Ongoing Exchanges of Interest:
    Once the principal amounts are established, the counterparties exchange interest payments based on the outstanding principal amounts at the respective fixed interest rates agreed at the outset of the transaction.
  3. Re-exchange of the Principal Amounts:
    On the maturity date the counterparties re-exchange the principal amounts established at the outset. This straight forward, three-step process is standard practice in the swap market and results in the effective transformation of a debt raised in one currency into a fully-hedged fixed-rate liability in another currency.

In principle, the fixed currency swap structure is similar to the conventional long –date forward foreign exchange contract. However, the counterparty nature of the swap market results in a far greater flexibility in respect of both maturity periods and size of the transactions which may be arranged. A currency swap structure also allows for interest rate differentials between the two currencies via periodic payments rather than the lump sum reflected by forward points used in the foreign exchange market. This enables the swap structure to be customized to fit the counterparties exact requirements at attractive rates. For example, the cash flows of an underlying bond issue may be matched exactly and invariably.

The Currency Coupon SWAP:
The currency coupon swap is combination of the interest rate swap and the fixed-rate currency swap. The transaction follows the three basic steps described for the fixed –rate currency swap with the exception that fixed-rate interest in one currency is exchanged for floating rate interest in another currency. By using the currency coupon swap the benefit which can be obtained, can be explained with the following example. Suppose an Indian corporate wished to enter a major leasing contract for a capital project to be sited in Japan. The corporate wanted to obtain the advantage of funding through a Japan’s lease which provided lower lease rentals due to the Japan tax advantages available to the Japan lessor. However, the Corporate was concerned by both the currency and interest rate exposure which would result from the yen based leasing contract. The structure provided by Hankers Trust enabled the Corporate to obtain the cost benefits available from the Japan lease and at the same time convert the underlying lease finance into a fully – hedged fixed-rate yen liability. Under the structure Bankers Trust paid, on a quarterly basis, the exact payments due on the Corporate’s yen based Japan lease in return for the Corporate paying an annual amount of fixed Japanese Yen to Banker’s Trust. The amount for fixed Japanese Yen payable reflected the beneficial level of the Japanese Yen lease payments.

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