Foreign Currency Swaps. CPA Exam.

In this video, I explain foreign currency swaps.
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Currency swaps and parallel loans are financial instruments used by companies to secure foreign currency for international trade or to protect against fluctuations in exchange rates. Let's break down both concepts and then illustrate them with an example.

Currency Swaps
A currency swap is an agreement between two parties to exchange principal and interest payments on loans issued in different currencies. Unlike a simple FX swap, which exchanges only the principal amounts with the intention of reversing the transaction at a later date, a currency swap involves swapping both principal and interest payments.

Here are the key features of a currency swap:

Exchange of Principal: The parties exchange principal amounts at the start of the agreement at a predetermined exchange rate. At the end of the agreement, they will reverse this exchange at either the same rate or the rate agreed upon at the start, which helps in mitigating exchange rate risk.
Interest Payments: During the life of the swap, each party makes interest payments on the borrowed currency. These payments can be fixed or floating, depending on the terms of the swap.
Risk Management: Companies use currency swaps to hedge against exchange rate fluctuations, to gain access to foreign capital markets, or to obtain cheaper debt than available domestically.
Parallel Loans
A parallel loan involves two parent companies in different countries lending to each other's subsidiary. This structure was created to avoid foreign exchange risk and any restrictions on the movement of capital between countries.

Key features include:

Direct Borrowing and Lending: Company A's parent lends to Company B's subsidiary, and vice versa.
Avoidance of FX Risk: Since the loans are in the respective domestic currencies, each company avoids FX risk.
Bilateral Nature: The agreement is directly between the two companies, involving the parent and subsidiary on both sides.
Example of a Currency Swap and Parallel Loan
Parallel Loan Example:

Company A is based in the USA and has a subsidiary in the UK.
Company B is based in the UK and has a subsidiary in the USA.
Company A’s US-based parent agrees to lend $10 million to Company B’s US subsidiary.
Simultaneously, Company B’s UK-based parent lends £8 million to Company A’s UK subsidiary.
The amounts are based on the current exchange rate, let’s say 1 USD = 0.8 GBP.
These loans are agreed to be repaid in 5 years.
This way, both companies get the foreign currency they need without having to exchange currency and thus avoid FX risk. The interest rates are agreed upon by both parties and paid to the respective lenders. After 5 years, the principal amounts are repaid, and the parallel loans are settled.

Currency Swap Example:

Company C in the US wants to expand its operations in Europe and needs €10 million. It can borrow in the US at 4% interest.
Company D in Europe wants to invest in US markets and needs $12 million. It can borrow in Europe at 3% interest.
However, Company C can borrow in Europe at 5% while Company D can borrow in the US at 6%.
They decide to enter into a currency swap.
Initial Exchange:

Company C borrows $12 million at 4% interest domestically.
Company D borrows €10 million at 3% interest domestically.
They swap the principal amounts, so Company C gets the €10 million it needs, and Company D gets the $12 million.
During the Life of the Swap:

Company C pays interest on €10 million at 3% to Company D.
Company D pays interest on $12 million at 4% to Company C.
These rates can be fixed or floating, and payments are usually netted against each other.
At Maturity:

Company C will return €10 million to Company D.
Company D will return $12 million to Company C.
The exchange rate risk is managed as they agreed on the exchange rate at the start of the swap.
In both the parallel loan and currency swap, the companies effectively manage their currency risks and finance their international needs in a cost-effective way. However, currency swaps are more common than parallel loans in today's markets due to their greater flexibility and easier implementation.