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General Misconception Of Currency Swap



The euphoria associated with the recent currency swap between Nigeria and China spurred my interest to understand this simple foreign currency transactional regime. Importers and exporters of goods in Nigeria went into excitement frenzy for the “supposed” good news that once the Central Bank of Nigeria (CBN) successfully swapped some of Nigeria’s foreign reserves, prices of imported goods from China would automatically reduce by 50 per cent. A mobile phone vendor in Abuja swore to me that within two weeks of the currency swap, the price of an apple phone X would crash from N380, 000 to less than N170,000.

The general idea of cheap or affordable goods from China filled the airwaves when the CBN contemplated to swap currency with the Chinese about two years ago. For some reason, the delay created undue nostalgia for the swap to materialize. Traders in Nigeria had been waiting for when the transaction between the two countries would happen.

Last month, it did happen. Nigeria swapped US$2.6 billion (obviously from its foreign reserves) with the Chinese Yuan. The ceremony was all over the news media, with positive comments in the social media. Very few analysts expressed negative reactions.

Unfortunately, Nigerians will be disappointed because the core reason for the swap is to borrow, at a much lower rate from China. It will have very little effect on trade between the two countries as viewed by the local importers and traders. The Naira, Nigeria’s currency, is not convertible in the foreign market regimes. The only option, which to me, makes very little sense, is the withdrawal from our foreign currency reserves to swap with the Yuan. It is, in effect, a counterpart funding for the proposed loan from China for infrastructure development, mainly the rail projects in Nigeria.

While a cheaper loan from China will support Buhari’s administration to upgrade the existing infrastructures (road, rail, airport expansion, etc.), we must understand that any loan from China comes with a stringent condition: Chinese firms must execute the project(s). It will benefit the Chinese more than Nigerians. But, in a country with endemic corruption, I’d rather appreciate the fact that the Chinese lenders must stipulate that their own companies perform the tasks than the local contractors.

What Is A ‘Foreign Currency Swap?

The purpose of engaging in a currency swap is usually to procure loans in foreign currency at more favorable interest rates than if borrowing directly in a foreign market. The World Bank first introduced currency swaps in 1981 in an effort to obtain German marks and Swiss francs. This type of swap can be done on loans with maturities as long as 10 years. Currency swaps differ from interest rate swaps in that they also involve principal exchanges.

In a currency swap, each party continues to pay interest on the swapped principal amounts throughout the length of the loan. When the swap is over, principal amounts are exchanged once more at a pre-agreed rate (which would avoid transaction risk) or the spot rate. In a typical currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received. Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another. An example of a cross currency swap for a EUR/USD transaction between a European and an American company follows: In a cross-currency basis swap, the European company would borrow US$1 billion and lend ‎€500 million to the American company assuming a spot exchange rate of US$2 per EUR for an operation indexed to the London Interbank Rate (Libor), when the contract is initiated.

Throughout the length of the contract, the European company would periodically receive an interest payment in euros from its counterparty at Libor plus a basis swap price, and it would pay the American company in dollars at the Libor rate. When the contract comes to maturity, the European company would pay US$1 billion in principal back to the American company and would receive its initial €500 million in exchange.

Differences Between Currency Swap And FX Swap

Among types of swaps, the Bank for International Settlements (or BIS) distinguishes “cross currency swaps” from “FX swaps.” Unlike in a cross-currency swap, in an FX swap there are no exchanges of interest during the contract term and a differing amount of funds is exchanged at the end of the contract. Given the nature of each, FX swaps are commonly used to offset exchange rate risk, while cross currency swaps can be used to offset both exchange rate and interest rate risk.

Cross currency swaps are frequently used by financial institutions and multinational corporations for funding foreign currency investments and can range in duration from one year to up to 30 years. FX swaps are typically used by exporters and importers, and institutional investors that seek to hedge their positions, and can range from one day to one year in duration, or longer.

According to the 2013 Triennial Central Bank survey from BIS, FX swaps were the most actively traded foreign exchange instruments, at upwards of US$2.2 trillion daily, or about 42 per cent of forex-related transactions. Trading of cross currency basis swaps, by contrast, totalled an average of US$54 billion daily.

Another popular strategy is to take a non-deliverable short position in a low-yielding currency and a long position in a high-yielding target currency. Upon settlement, the purchaser receives, or pays, the difference between the forward rate and the spot rate if the target currency appreciates or depreciates in relation to the agreed-upon price of the non-deliverable forward. This strategy is popular because the transaction involving a non-deliverable contract can be made with a relatively smaller initial investment than with alternative strategies.

Summary: The Swap Debate

Although an integral part of the global derivatives market, many kinds of swaps remain controversial. During the credit crisis of 2008, credit default swaps (CDS) pertaining to the U.S. real estate market were deemed to be one of the primary culprits responsible for the meltdown. The subsequent failure of numerous investment banks and insurance companies were attributed to these activities, giving the term “swap” a somewhat negative connotation.

Source: Wikipedia