Multinational Finance, 6th Edition

Chapter 7Currency Swaps and Swaps Markets

Never take a job for which you have to change clothes.

— Henry David Thoreau

A swap is a derivative instrument in which counterparties exchange one stream of cash flows for another. In a currency swap, the cash flows are in two different currencies. The most common form of currency swap trades a fixed interest rate in one currency for a floating interest rate in another. Although both principal and interest payments could be exchanged, in most currency swaps the principal is not exchanged and only a difference check recognizing the difference in the interest payments is exchanged. The principal amount in a swap is called the notional principal because it determines the size of the interest payments on each side of the swap, and might or might not be exchanged. An interest rate swap is similar, except the principal amounts are in the same currency. There is no need to exchange the principal in an interest rate swap.

Suppose British Petroleum has a U.S. oil refinery that generates cash flows in U.S. dollars. Although BP's functional currency is the British pound and much of its debt is denominated in pounds, fixed rate dollar debt could hedge the operating cash flows of BP's U.S. refinery. A floating-for-fixed currency swap with a commercial or investment bank could accomplish this hedge without having to incur the costs of issuing new dollar-denominated debt. Swap contracts such as these provide cost-effective vehicles for quickly transforming ...