Hedging Risk with Currency Swaps

Currency risk is the financial risk that arises from potential changes in the exchange rate of one currency in relation to another. And it's not just those trading in the foreign exchange markets that are affected. Adverse currency movements can often crush the returns of a portfolio with heavy international exposure, or diminish the returns of an otherwise prosperous international business venture. Companies that conduct business across borders are exposed to currency risk when income earned abroad is converted into the money of the domestic country, and when payables are converted from the domestic currency to the foreign currency.

The currency swap market is one way to hedge that risk. Currency swaps not only hedge against risk exposure associated with exchange rate fluctuations, but they also ensure receipt of foreign monies and achieve better lending rates.

A currency swap is a financial instrument that involves the exchange of interest in one currency for the same in another currency.

Currency swaps comprise two notional principals that are exchanged at the beginning and end of the agreement. These notional principals are predetermined dollar amounts, or principal, on which the exchanged interest payments are based. However, this principal is never actually repaid: It's strictly "notional" (which means theoretical). It's only used as a basis on which to calculate the interest rate payments, which do change hands.

Here are some sample scenarios for currency swaps. In real life, transaction costs would apply; they have been omitted in these examples for simplification.

1. Party A pays a fixed rate on one currency, Party B pays a fixed rate on another currency.

A U.S. company (Party A) is looking to open up a €3 million plant in Germany, where its borrowing costs are higher in Europe than at home. Assuming a 0.6 euro/USD exchange rate, the company can borrow €3 million at 8% in Europe or $5 million at 7% in the U.S. The company borrows the $5 million at 7% and then enters into a swap to convert the dollar loan into euros. Party B, the counterparty of the swap may likely be a German company that requires $5 million in U.S. funds. Likewise, the German company will be able to attain a cheaper borrowing rate domestically than abroad—let's say that the Germans can borrow at 6% within from banks within the country's borders.

Now, let's take a look at the physical payments made using this swap agreement. At the outset of the contract, the German company gives the U.S. company the €3 million needed to fund the project, and in exchange for the €3 million, the U.S. company provides the German counterparty with $5 million.

Subsequently, every six months for the next three years (the length of the contract), the two parties will swap payments. The German firm pays the U.S. company the sum that's the result of $5 million (the notional amount paid by the U.S. company to the German firm at initiation), multiplied by 7% (the agreed-upon fixed rate), over a period expressed as .5 (180 days ÷ 360 days). This payment would amount to $175,000 ($5 million x 7% x .5). The U.S. company pays the Germans the result of €3 million (the notional amount paid by the Germans to the U.S. company at initiation), multiplied by 6% (the agreed-upon fixed rate), and .5 (180 days ÷ 360 days). This payment would amount to €90,000 (€3 million x 6% x .5).

The two parties would exchange these fixed two amounts every six months. Three years after initiation of the contract, the two parties would exchange the notional principals. Accordingly, the U.S. company would "pay" the German company €3 million and the German company would "pay" the U.S. company $5 million.

2. Party A pays a fixed rate on one currency, Party B pays a floating rate on another currency.

Using the example above, the U.S. company (Party A) would still make fixed payments at 6% while the German company (Party B) would pay a floating rate (based on a predetermined benchmark rate, such as LIBOR).

These types of modifications to currency swap agreements are usually based on the demands of the individual parties in addition to the types of funding requirements and optimal loan possibilities available to the companies. Either party A or B can be the fixed rate pay while the counterparty pays the floating rate.

3. Part A pays a floating rate on one currency, Party B also pays a floating rate based on another currency.

In this case, both the U.S. company (Party A) and the German firm (Party B) make floating rate payments based on a benchmark rate. The rest of the terms of the agreement remain the same.

Recall our first plain vanilla currency swap example using the U.S. company and the German company. There are several advantages to the swap arrangement for the U.S. company. First, the U.S. company is able to achieve a better lending rate by borrowing at 7% domestically as opposed to 8% in Europe. The more competitive domestic interest rate on the loan, and consequently the lower interest expense, is most likely the result of the U.S. company being better known in the U.S. than in Europe. It is worthwhile to realize that this swap structure essentially looks like the German company purchasing a euro-denominated bond from the U.S. company in the amount of €3 million.

The advantages of this currency swap also include assured receipt of the €3 million needed to fund the company's investment project. Other instruments, such are forward contracts, can be used simultaneously to hedge exchange rate risk.

Investors benefit from hedging foreign exchange rate risk as well.

Using currency swaps as hedges is also applicable to investments in mutual funds and ETFs. If you have a portfolio heavily weighted towards United Kingdom stocks, for instance, you’re exposed to currency risk: The value of your holdings can decline due to changes in the exchange rate between the British pound and the U.S. dollar. You need to hedge your currency risk to benefit from owning your fund over the long term.

Many investors can reduce their risk exposure by using currency-hedged ETFs and mutual funds. A portfolio manager who must purchase foreign securities with a heavy dividend component for an equity fund could hedge against exchange rate volatility by entering into a currency swap in the same way as the U.S. company did in our examples. The only downside is that favorable currency movements will not have as beneficial an impact on the portfolio: The hedging strategy's protection against volatility cuts both ways.

Companies that have exposure to foreign markets can often hedge their risk with currency swap forward contracts. Many funds and ETFs also hedge currency risk using forward contracts.

A currency forward contract, or currency forward, allows the purchaser to lock in the price they pay for a currency. In other words, the exchange rate is set in place for a specific period of time. These contracts can be purchased for every major currency.

The contract protects the value of the portfolio if exchange rates make the currency less valuable—protecting a U.K.-oriented stock portfolio if the value of the pound declines relative to the dollar, for example. On the other hand, if the pound becomes more valuable, the forward contract isn’t needed, and the money to buy it was wasted.

So, there is a cost to buying forward contracts. Funds that use currency hedging believe that the cost of hedging will pay off over time. The fund's objective is to reduce currency risk and accept the additional cost of buying a forward contract.

A hedged portfolio incurs more costs but can protect your investment in the event of a sharp decline in a currency’s value.

Consider two mutual funds that are made up entirely of Brazilian-based companies. One fund does not hedge currency risk. The other fund contains the exact same portfolio of stocks, but purchases forward contracts on the Brazilian currency, the real.

If the value of the real stays the same or increases compared to the dollar, the portfolio that is not hedged will outperform, since that portfolio is not paying for the forward contracts. However, if the Brazilian currency declines in value, the hedged portfolio performs better, since that fund has hedged against currency risk.

Currency risk doesn't only affect companies and international investors. Changes in currency rates around the globe result in ripple effects that impact market participants throughout the world.

Parties with significant forex exposure, and hence currency risk, can improve their risk-and-return profile through currency swaps. Investors and companies can choose to forgo some return by hedging currency risk that has the potential to negatively impact an investment.