Currency Swaps and Hedging of Foreign Exchange Operating Exposures

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Table of Contents

Introduction
Currency swaps and hedging of foreign exchange operating exposures
Advantages of currency swaps
Conclusion
References

Introduction

Every country uses a unique currency denomination in purchases and exchange of goods and services within its territorial boundaries making it more complicated to have the value of one country’s currency equate to another one from a different country. The most internationally accepted currency is the dollar; however, there have been attempts by countries and regions to establish a common currency within a trade zone, some of which have been successful e.g. the euro within Europe. A common currency makes trade easy and makes the estimations of standards of living for people in that zone possible. This paper will seek to analyze currency swaps in the global market and provide an explanation of how currency swaps hedge foreign exchange operation exposure and the accounting advantages associated with them.

Currency swaps and hedging of foreign exchange operating exposures

A currency swap is the exchange of principal amount and interest in one currency to acquire another currency from another party. Currency swaps can be of four different types depending on the prevailing terms and conditions; Plain vanilla or genetic swaps, amortizing swaps, zero-coupon swaps, and differential swaps. The currency swap has five elements that have to be deliberated on by the two parties, which include; the period of the agreement, the currencies to be exchanged, the principal amount of every currency, and the exchange rate, the basis for the exchange, and how soon the exchange of the principal amount should be (Coyle, 2000, p. 57).

It is important to know that the currency swaps are aimed at hedging or mitigating foreign exchange interest rates. The currency exposures and uncertainty which amounts to foreign exchange are among the factors which cause interest rate changes (Brown & Smith, 1995, p. 83). When restructuring swap transactions, various factors are significantly considered among them being the accounting, enterprise, and tax risks that influence a transaction. To hedging the exposure risk, the swap managers make a bid-offer spread in the credit adjustment. In such a scenario, the credit quality of the dealer determines whether the bid-offer spread will widen or not. Since the potential risk is bilateral, a weak dealer will have a narrow bid-offer spread, the reason of which the super nationals and other big corporations limit their swap activities to only the strong counterparts (Kolb & Overdahl, 2003, p.168). By doing so, they widen their bid-offer spread. The currency swaps enable firms to have a comparative advantage in their respective borrowing markets especially when considering the flexibility according to the currency swaps. Indeed, banks mostly protect themselves against foreign currency risks by calculation their total net exposure to each currency, in addition to applying modern off-balance sheet and on-balance sheet accounting methods to control the risks (Angelopoulos & Mourdoukoutas, 2001, p. 36).

Advantages of currency swaps

There are various accounting advantages of currency swaps. First, they are easy to compute, simply because they are fixed within a certain duration of time. The fixed swap is mainly observed in the plain vanilla type. Second, as noted by Kolb (2003) currency swaps restricts the movement of cash flow between nations and other multinational corporations, thus regulation trade between them. The currency swaps enable the multinational corporations to evade currency controls that would otherwise be undertaken by the various central banks of the countries. It is also important to note that IAS 11 relieves the firm’s balance sheet disclosure obligation. It is therefore optional for firms to decide on whether to disclose the gain or loss obtained through hedging instruments such as swaps. Both domestic and international banks take advantage of the accounting standards to maximize their profits (Lewis & Davis, 1987pg117).

Conclusion

Currency swaps allow companies across the world to effectively and efficiently exploit the global capital markets as well as linking and arbitrating between the various interest rates of the different developed countries. It is also important to acknowledge that the banking future trend is leaning towards diversification and ensuring that all loan portfolios are secured, an event which can only be necessitated by allowing currency swaps to play their integral role in the market transformation.

References

Angelopoulos, P. & Mourdoukoutas, P. (2001). Banking risk management in a globalizing economy. NY: Greenwood Publishing Group. Web.

Brown, K.C & Smith, D.J. (1995). Interest rate and currency swaps: a tutorial. London: Wiley-Blackwell. Web.

Coyle, B. (2000). Currency swaps. London: Lessons Professional Publishing. Web.

Kolb, R. W. (2003). Futures, options, and swaps. London: Wiley-Blackwell. Web.

Kolb, R.W. & Overdahl, J. A. (2003). Financial derivatives. New Jersey: John Wiley and Sons. Web.

Lewis, M. & Davis, K. (1987). Domestic and international banking. London: MIT Press. Web.

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Currency Swaps and Hedging of Foreign Exchange Operating Exposures

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