The difference between currency swaps and rate swaps
Rate swaps are agreements that are made between two different corporations or companies to exchange cash flows based on a particular variable. Most of the time, this variable is an interest rate, but it can also be the price of a share, the exchange rate or the price of a commodity. These swaps allow companies to reduce the amount of risk experienced by private parties in the market.
Swaps are not exchange-traded instruments, but contracts that are traded as over-the-counter derivatives on the market. Because of this, most of those who use interest rate swaps are financial institutions and companies, and very few people participate in this risk management strategy.
Most of the time, there are two basic swaps that corporations and businesses use: simple interest rate swaps and currency swaps. In other articles, we have discussed the main features and benefits of a simple swap, but today we are going to talk about currency swaps. Next, you will learn what currency swaps are and how they differ from standard interest rate swaps.
Currency exchanges vs. interest rate swaps
The definition of a currency swap is basically the same as any other rate swap. However, there are some unique differences between the two. However, one of the most important is the fact that this type of exchange allows the exchange of capital. Many times this is done because a company can reduce its potential risk by taking on debt in a different currency.
There are three ways a currency exchange can be used, due to this monumental difference.
- Equity exchange only- The most basic exchange that can occur is one that involves only principles. Both parties agree to swap their debt, which is often two different types of currencies in an effort to lock in forward rates in a profitable manner. This type of exchange itself is often called a currency exchange.
- Principal and interest- Currency swaps differ from regular rate swaps in that they allow both principal and interest rates to be exchanged. Another difference, when both are traded using this method, is that, unlike a straight swap, the interest cash flows are not offset before the counterparty is paid due to the difference between the two currencies being traded. . This type of exchange is often called a backing loan.
- Only interest- As with a simple rate swap, currency swaps allow for interest-only swaps. However, as before, the cash flows cannot be cleared before delivery to the counterparty due to the different currencies used. This type of exchange is often called a cross currency swap.
While currency swaps are not always the right choice for companies that could benefit from alternative derivatives, they can sometimes be an excellent solution when different currencies are involved and standard currency swaps just don’t work.
If you need to manage your risk and want to trade loans, consider what type of trade you might benefit from most. They each have their advantages, but they differ in their abilities.
