Currency Swaps and Currency Futures.

Currency swaps involve an exchange of cash flows in two different currencies. It is

generally used to raise funds in a market where the corporate has a comparative
advantage and to achieve a portfolio in a different currency of his choice, at a cost
lower than if he accessed the market of the second currency directly. However,
since these types of swaps involve an exchange of two currencies, an exchange
rate, generally the prevailing spot rate is used to calculate the amount of cash
flows, apart from interest rates relevant to these two currencies. By its special
nature, these instruments are used for hedging risk arising out of interest rates and
exchange rates.
A currency swap is a contract which commits two counter parties to an exchange,
over an agreed period, two streams of payments in different currencies, each
calculated using a different interest rate, and an exchange, at the end of the period,
of the corresponding principal amounts, at an exchange rate agreed at the start of
the contract.
Bank UK commits to pay Bank US, over a period of 2 years, a stream of interest on
USD 14 million, the interest rate is agreed when the swap is negotiated; in
exchange, Bank US commits to pay Bank UK, over the same period, a counter
stream of sterling interest on GBP 10 million; this interest rate is also agreed when
the swap is negotiated. Bank UK and Bank US also commit to exchange, at the end
of the two year period, the principals of USD 14 million and GBP 10 million on which
interest payments are being made; the exchange rate of 1.4000 is agreed at the
start of the swap.

We can now see from the above that currency swaps differ from interest rate swaps in that
currency swaps involve:

An exchange of payments in two currencies.

Not only exchange of interest, but also an exchange of principal amounts.

Unlike interest rate swaps, currency swaps are not off balance sheet instruments since
they involve exchange of principal at the end of the period.

The idea of entering into the currency swap is that, Bank US is probably expecting an
amount of GBP 10 million at the end of the period, while Bank UK is expecting an
amount of USD 14 million, which they agreed to exchange at the end of the period at a
mutually agreed exchange rate.

The interest payments at various intervals are calculated either at a fixed interest rate or a
floating rate index as agreed between the parties.

Currency swaps can also use two fixed interest rates for the two different currencies
different from the interest rate swaps.

The agreed exchange rate need not be related to the market.

The principal amounts can be exchanged even at the start of the swap

If in the above-mentioned swap, the two banks agree to exchange the principal at the beginning.

Bank UK will sell GBP to Bank US in exchange for US Dollars.

This would be at an exchange rate, most likely the spot rate.

These banks would borrow the respective currencies, which they have sold.

But at maturity, this exchange of principal would be reversed at the original exchange
rate. (This kind of swap is called a par swap).
Cross-currency coupon swaps:
These are fixed-against-floating swaps.
Cross-currency basis swap:
These swaps involve payments attached to a floating rate index for both the
currencies. In other words, floating-against-floating cross-currency basis
swaps.
Risk Management with currency swaps:
Example: (Principal exchanged at Maturity)
A UK Co. With mainly sterling revenues, has borrowed fixed-interest dollars in
order to purchase machinery from the U.S. It now expects the GBP to
depreciate against the USD and is worried about increase in its cost of
repayment.
It could now hedge its exposure to a dollar appreciation by using a GBP/USD
currency swap. It would fix the rate at which the company, at maturity, could
exchange its accumulated sterling revenues for the dollars needed to repay
the borrowing. Fixing the exchange rate hedges the currency risk in borrowing
dollars and repaying through sterling.
Assuming, the Company expects not only the dollar to appreciate, but also

the GBP interest rates to fall. It could take advantage of this situation, by
swapping from fixed-interest dollars into floating interest sterling.

Stages:

At the start of the swap, the GBP/USD rate is agreed at which the principal amounts will
be exchanged at maturity (probably, the prevailing GBP/USD spot rate)

At the same time, interest rates for use in the swap are also agreed

Over the life of the swap, the UK Company will pay a stream of sterling floating interest
through the swap and will receive a counter stream of dollar fixed interest in exchange.
The dollar interest received through the swap will be used to service the dollar
borrowing; the sterling interest paid through the swap will be funded from earnings.

At maturity, the company will pay a sterling principal amount through the swap and
receive a dollar principal amount in exchange. The exchange is made at the GBP/USD
rate agreed at the start of the swap. The company will fund its payment of principal
through the swap from accumulated sterling earnings from its business and will use the
dollar principal it receives in exchange to repay its dollar borrowing
Example: (Principal exchanged at the beginning)
This will be the case when the UK co. wants to swap its dollar loan into a
sterling loan, but needs dollars at the outset to pay for dollar imports or for
any other purpose. In this case, the UK co. would simply acquire the dollars
from the spot foreign exchange market. It would fund this spot purchase of
dollars with the sterling received through the swap in the initial exchange of
principal amounts

Stages:

At the start of the swap, the UK co. buys dollars against sterling in the spot market.

The dollar bought in the spot are exchanged through the swap for sterling, at the same
GBP/USD exchange rate at which the UK co. had to buy dollars against sterling in the
spot market; the sterling received through the swap is used to fund the spot purchase of
the dollars.

At the same time, the GBP/USD rate at which the principal amounts will be exchanged at
maturity is fixed at the spot rate at which the UK co. had to buy dollar against sterling in
the spot.

The interest rates for use in the swap are also agreed;

Over the life of the swap, the UK co. will pay a stream of sterling interest through the
swap and will receive a counter stream of dollar interest in exchange. The dollar interest

received will be used to service to the dollar borrowing; the sterling interest paid through
the swap will be funded from earnings.

At maturity, the co. will pay a sterling principal amount through the swap and receive a
dollar principal amount in exchange. The exchange is made at the GBP/USD rate agreed
at the start of the swap. The co. will fund its payment of principal through the swap from
accumulated sterling earnings from its operations and will use the dollar principal, it
receives in exchange, to repay its dollar borrowing.

Swap Market in India.

In India, the Reserve Bank of India has permitted banks to arrange currency swaps with
one currency leg being Indian Rupee. However, the USD/INR forward foreign exchange
markets are illiquid beyond one year. Since currency swaps involve the forward foreign
exchange markets also, there are limitations to entering the Indian Rupee currency swaps
beyond twelve months. Moreover, banks are also not allowed to take risk /run open swap
books i.e., they have to locate counter parties with matching requirements; e.g. one
desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange
rupee debt servicing obligation for dollar obligations. However, some aggressive banks
do provide quotes for currency swaps for three to five years out for reasonable size
transactions.
Corporates who have huge rupee liabilities and want have foreign currency loans in their
books, both as a diversification as well as a cost reduction exercise could achieve their
objective by swapping their rupee loans into foreign currency loans through the
dollar/rupee swap route. However, the company is assuming currency risk in the process
and unless carefully managed, might end up increasing the cost of the loan instead of
reducing it. In India, it is more the norm for corporates to swap their foreign currency
loans into rupee liabilities rather than the other way round

Example:
A corporate has a loan of USD 10 million outstanding with remaining maturity of 2
years, interest on which is payable every six months linked to 6-month Libor + 150
basis points. This dollar loan can be effectively converted into a fixed rate rupee
loan through a currency swap. If the corporate wants to enter into a currency swap
to convert his loan interest payments and principal into INR, he can find a banker
with whom he can exchange the USD interest payments for INR interest payments
and a notional amount of principal at the end of the swap period. The banker quotes
a rate of say 10.75% for a USD/INR swap. The total cost for the corporate would now
work out to 12.25%. If the spot rate on the date of transaction is 44.65, the rupee
liability gets fixed at Rs. 446.50 mio. At the end of the swap, the bank delivers USD
10 million to the corporate for an exchange of INR 446.50 mio, which is used by the
corporate to repay his USD loan. The corporate is able to switch from foreign
currency.

Currency Futures
A transferable futures contract that specifies the price at which a currency can be
bought or sold at a future date. Currency future contracts allow investors to hedge
against foreign exchange risk. Currency futures are settled in cash in India.
For more details on currency futures please click on the foll link.
http://www.nseindia.com/content/ncfm/CDBM_workbook.pdf

References
http://www.nseindia.com/content/ncfm/CDBM_workbook.pdf
http://www.mecklai.com/Market_Resources.aspx?
name=Mecklai_Knowledge_Centre/TutorialMain