Hedging With Currency Swaps
By Matt Cavallaro AAA |
The volume of wealth that changes hands in the currency market dwarfs that of all other financial markets. Specialist brokers, banks, central banks, corporations, portfolio managers, hedge funds and retail investors trade staggering volumes of currencies throughout the world on a continuous basis. (There are no strictly-forex programs, but there are still some advanced education alternatives for forex traders. See 5 Forex Designations.) TUTORIAL: Top 10 Forex Trading Rules
Because of the sheer size of transactions in the currency market, participants are exposed to currency risk. This is the financial risk that arises from potential changes in the exchange rate of one currency in relation to another. Adverse currency movements can often crush positive portfolio returns or diminish the returns of an otherwise prosperous international business venture. The currency swap market is one way to hedge that risk. Currency Swaps
A currency swap is a financial instrument that helps parties swap notional principals in different currencies and thus pay interest payments on the received currency. The purpose of currency swaps is to hedge against risk exposure associated with exchange rate fluctuations, ensure receipt of foreign monies, and to achieve better lending rates. Currency swaps are comprised of two notional principals that are exchanged at the beginning and at the end of the agreement. Companies that have exposure to foreign markets can often hedge their risk with four specific types of currency swap forward contracts (Note that in the following examples, transaction costs have been omitted to simplify explaining payment structure): Party A pays a fixed rate on one currency, Party B pays a fixed rate on another currency. Consider a U.S. company (Party A) that is looking to open up a plant in Germany where its borrowing costs are higher in Europe than at home. Assuming a 0.6 Euro/USD exchange rate, the...
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