A swap is an agreement to exchange one stream of cashflows for another. Swaps are most commonly used to:
- switch financing in one currency for financing in another
- to replace a floating interest rate with a fixed interest rate (or vice versa).
Swap transactions are usually large.
Currency swaps may be used where a borrower can get a better rate in one currency, but where the borrowing is linked to assets or cashflows in another and therefore a currency rate risk can be eliminated by borrowing in the latter currency.
A company in this position can do is to borrow in the currency in which they get the better rate (often the company's home country), and then enter into an agreement with another party (usually a bank) , in which the counterparty pays the original debt in exchange for a stream of (fixed) payments in the other currency. For example:
Company A needs Yen to fund its new Japanese operation, but as it is not well known in Japan it finds it hard to raise debt there.
It borrows in Euros, on which it is able to get a good rate. It sells the Euros for Yen which provides the funding, but this leaves its Japanese operation, which will earn Yen, with a Euro debt.
A therefore enters into an agreement with a bank whereby the bank pays the Euro debt off (as it falls due) in exchange for payments in Yen, the amounts of all payments being fixed at the start of the agreement. This effectively leaves the Japanese operation with a liability in Yen, matched to its revenues.
Interest rates swaps involve exchanging one set of interest payments for another, which may be in the same currency. A common motivation for this is to swap a floating interest rate for a fixed interest rate.