While the cost of borrowing in the international market is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities. Currency swaps are an essential financial instrument utilized by banks, multinational corporations, and institutional investors. Although these type of swaps function in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that make currency swaps unique and thus slightly more complicated. One purpose of engaging in a currency swap is to procure loans in foreign currency at more favorable interest rates than might be available borrowing directly in a foreign market.

First, it updates the stylised facts concerning FX swaps/forwards and currency swaps. Second, it measures the missing dollar debt for non-banks resident outside the United States, and for banks headquartered outside the United States. This was evident during the Great Financial Crisis (GFC) and again in March 2020 when the Covid-19 pandemic wrought havoc.

The fourth delves into banks’ role, tracing banking systems’ post-GFC reliance on the market for funding. Just how large is the missing dollar debt from FX swaps/forwards and currency swaps? At end-June 2022, dealer banks had $52 trillion in outstanding dollar positions with customers. Non-banks had dollar obligations of half of this amount, $26 trillion.4 This sum has been growing strongly, from $17 trillion in 2016 (Graph 2.B). Therefore, while foreign exchange swaps are riskless because the swapped amount acts as collateral for repayment, cross currency swaps are slightly riskier. There is default risk in the event the counterparty does not meet the interest payments or lump sum payment at maturity, meaning the party cannot pay their loan.

Company A and Swiss Company B can take a position in each other’s currencies (Swiss francs and USD, respectively) via a currency swap for hedging purposes. 8 Only 1% of FX transactions are centrally cleared (Wooldridge (2017)), and most of those remain limited to non-deliverable forwards (McCauley and Shu (2016)). At end-2007, before interest rate swaps were centrally cleared, the inter-dealer share of such positions stood at almost 40%. It can deliver the bonds to a swap bank, which then passes it on to Company B. Company B reciprocates by issuing an equivalent bond (at the given spot rates), delivers to the swap bank and ends up sending it to Company A.

FX swaps/forwards and currency swaps: some stylised facts

Third, European supranationals and agencies have opportunistically borrowed dollars to swap into euros to lower their funding costs. While their operations mostly require euros, they have done so to take advantage of the breakdown in covered interest parity (Borio et al (2016)). Five European supranationals and agencies together had over $400 billion in dollar debt in June 2017. We estimate that these alone have provided $300 billion in swaps against the euro. The forward creates an obligation to come up with foreign currency (a liability), matched by the right to receive the domestic currency (an asset), both equal to the current value of the foreign currency asset.

The first source is the BIS derivatives statistics, which draw on reports from 73 global dealer banks. FX swaps and forwards are treated together since, as noted above, after the spot exchange only the forward position survives. That said, BIS statistics on FX turnover show that FX swaps are the modal instrument (see below).

Drilling down to non-financial and financial customers

Second, they could be used as tools to hedge exposure to exchange rate risk. Corporations with international exposure utilize these instruments for the former purpose while institutional investors would typically implement currency swaps as part of a comprehensive hedging strategy. For their part, several large European banking systems also draw dollars from the FX swap market to fund their international dollar positions (top centre panel). Pre-GFC, German, Dutch, UK and Swiss banks, in particular, had funded their growing dollar books via interbank loans (blue lines) and FX swaps (shaded area). The meltdown in dollar-denominated structured products during the crisis caused funding markets to seize up and banks to scramble for dollars.

7 The gross market value of these positions amounted to $1.5 trillion ($1.3 trillion for dollars) at end-2016. The third source includes ad hoc surveys on institutional investors’ and asset managers’ use of derivatives. Thus, central bankers at the BIS appear concerned about the potential ramifications of too much money trading hands in the shadows. Accordingly, there are worries that the scale of such transactions could lead to problems on the horizon.

1. The only difference is that in case 3 the agent has the freedom to use the domestic currency cash to buy another domestic currency asset rather than having it tied up in a forward claim.
2. At maturity, each company will pay the principal back to the swap bank and, in turn, receive its original principal.
3. However, given the activity of hedge funds in the currency swap market, the 80% should be regarded as an upper bound on non-bank financial firms’ hedging.

An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from the unwillingness of Brazilian banks to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable interest rate in the U.S. market.

The Process of a Foreign Currency Swap

Although Company B swapped BRL for USD, it still must satisfy its obligation to the Brazilian bank in real. As a result, both companies will incur interest payments equivalent to the other party’s cost of borrowing. This last point forms the basis of the advantages that a currency swap provides. They offer a company access to a loan in a foreign currency that can be less expensive than when obtained through a local bank. They also provide a way for a company to hedge (or protect against) risks it may face due to fluctuations in foreign exchange.

Markets calmed only after coordinated central bank swap lines to supply dollars to non-US banks became unlimited in October 2008. The $6.6 trillion in currency swaps that non-bank financial firms have contracted stand at almost 80% of their outstanding international https://www.tradebot.online/ debt securities. Regression analysis supports such a high hedge ratio (Table 3, third and fourth columns). However, given the activity of hedge funds in the currency swap market, the 80% should be regarded as an upper bound on non-bank financial firms’ hedging.

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It also may be more expensive to borrow in the U.S. than it is in another country, or vice versa. In either circumstance, the domestic company has a competitive advantage in taking out loans from its home country because its cost of capital is lower. First, let’s take a step back to fully illustrate the purpose and function of a currency swap.

The lack of direct information makes it harder for policymakers to anticipate the scale and geography of dollar rollover needs. Thus, in times of crisis, policies to restore the smooth flow of short-term dollars in the financial system (eg central bank swap lines) are set in a fog. For simplicity, the aforementioned example excludes the role of a swap dealer, which serves as the intermediary for the currency swap transaction. With the presence of the dealer, the realized interest rate might be increased slightly as a form of commission to the intermediary.

The two companies make the deal because it allows them to borrow the respective currencies at a favorable rate. Company B. Concurrently, U.S Company A borrows 100 million euros from European Company A. With mounting global macroeconomic concerns tied to rising interest rates and inflation, this isn’t easy news to hear.

During the financial crisis in 2008, the Federal Reserve allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes. US non-banks have sold only $600 billion in non-dollar-denominated debt to non-residents (US Treasury et al (2016)). Many leveraged accounts (eg Commodity Trading Advisor funds) sell dollars in the futures market rather than in the OTC market. ETFdb.com data show that, out of the top 22 exchange-traded funds that invest in Japanese equities, those with “hedged” in the fund title had combined assets of $29 billion.