Purposes of Currency Swaps

The motivations for the various forms of currency swap are similar to those that generate a demand for interest rate swaps. The incentive may arise from a comparative advantage that a borrowing company has in a particular currency or capital market. It may result from a company’s desire to diversify and spread its borrowing around to different capital markets, or to shift a cash flow from foreign currencies. It may be that a company cannot gain access to a particular capital market. Or, it may reflect a move to avoid exchange controls, capital controls, or taxes. Any number of possible “market imperfections” or pricing inconsistencies provide opportunities for arbitrage.

Before currency swaps became popular,parallel loans and back-to-back loans were used by market participants to circumvent exchange controls and other impediments. Offsetting loans in two different currencies might be arranged between two parties; for example, a U.S. firm might make a dollar loan to a French firm in the United States, and the French firm would lend an equal amount to the U.S. firm or its affiliate in France. Such structures have now largely been abandoned in favor of currency swaps.

Because a currency swap, like an interest rate swap, is structurally similar to a forward, it can be seen as an exchange and re-exchange of principal plus a “portfolio of forwards”—a series of forward contracts, one covering each period of interest payment. The currency swap is part of the wave of financial derivative instruments that became popular during the 1980s and ‘90s. But currency swaps have gained only a modest share of the foreign exchange business. It has been suggested that the higher risk and related capital costs of instruments involving an exchange of principal may in part account for this result.