A currency swap involves two principal amounts, one for each currency. There is an exchange of the principal amounts and the rate generally used to determine the two principal amounts is the then prevailing spot rate. Alternatively, the parties to the swap transaction can also enter into delayed/forward start swaps by agreeing to use the forward rate.
A currency swap is similar to a series of foreign exchange forward contracts, which are agreements to exchange two streams of cash flows in different currencies. Like all forward contracts, the currency swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency and the swap leg the party agrees to receive is an asset in the other currency.
Consider a case of a corporate having a long term borrowing in USD. He can enter into following types of currency swaps to hedge the risks:
Types of currency swaps
The first mentioned swap is generally the preferred swap. In the stated case, the customer enters into the swap with the bank to receive floating interest rate (USD Libor) payments and USD principal and simultaneously pays INR fixed interest rate and equivalent INR principal amount arrived at based on the spot rate prevailing on the transaction date.
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into currency swaps only for the purpose of hedging the interest rate risk on the underlying asset/liability.
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