Currency swap agreements defined and Japan and South Korea agreement
Currency swaps or cross-currency swap is a financial vehicle that involves the exchange of interest and can also be the exchange of principal in one specific currency for another currency. When a currency swap takes place, the contract has a fixed date. Currency swaps should be considered foreign exchange transactions. Also, currency swaps don't have to be disclosed on the financial statements of the entity's balance sheets.
Countries and businesses use currency swaps for several reasons. The first reason a govern- ment or corporation will use a currency swap is that it provides foreign exchange exposure. Currency swaps can also be used to lower the cost of financing because borrowing in a foreign currency is less expensive.
One of the most important reasons a country or company will enter into a currency swap is that it allows these entities to access a foreign currency. These swaps are used so that one side can pay in another cash. Lastly, currency swaps are a valuable exchange because the country or company can take advantage of the interest rate differences.
An excellent example of a swap currency deal is the most recent exchange between Japan and South Korea.
Why did Japan and South Korea swap currency?
On June 29th, 2023, Japan and South Korea agreed to swap 10 billion dollars worth of currency. The deal to swap currency was initially put in place back in 2001, and it was used to assist each country and combat a financial disaster. However, the deal/pact was never used and expired in 2015. Japan and South Korea have had diplomatic issues for years, and the new agreement will help improve the nation's ties.
The reason for the currency swap was not directly related to the stabilization of exchange rates between the two countries but more so to prompt economic exchanges between the two countries. The president of South Korea Yoon Suk Yeol has been working hard to improve relations between the two countries since he took office last year in 2022.
Under the new agreement, Japan and South Korea will have the option of exchanging their local currencies when needed and typically during times of crisis for either country. The deal is believed to last roughly three years, according to finance minister Choo Kyung-ho of South Korea, which is typical with this type of agreement. It is also believed that the swap deal will most likely not be used for some time, considering both countries have significant currency reserves.'
There are several different types of currency swaps. A fixed-for floating currency swap is one in which two different parties (either counties, financial institutions, or corporations) swap interest cash flows from fixed-rate loans for those of floating-rate loans. In this type of swap, the loan's principal is not part of the exchange. An entity will do this type of transaction because the swap reduces the interest expense through swapping for a floating rate if the floating rate is lower than the fixed rate when it is being paid. The swap is similar to a currency forward transaction or a CFD trading process with the underlying currency pair.
In addition, the fixed for floating rate transaction allows the country, financial institution, or company to match assets and liabilities that might be sensitive to interest rate fulgurations.
So, when analyzing fixed floating rate transactions, one should consider the following. The transaction is used to reduce interest expenses by swapping a fixed rate for a floating rate if the floating rate is lower, diversify risk within a loan portfolio by exchanging the fixed rate for a floating rate, and create a financial hedge with the understanding that overall market interest rates will go down.
A basis or float vs. float swap is the exchange of two floating rates. When using a basis swap, the country, financial institution, or company is swapping one floating rate for the other. The basis swaps exist because the entities are looking to reduce basis risk. Basis risk happens when cash flows are affected by factors that are not perfectly correlated. An excellent example is when you have a financial institution with floating-rate assets and floating-rate liabilities. One might think that if interest rates go up, both the assets and liabilities are tied to a floating rate, so there would not be any effect on the bank's net interest income. However, if the floating rate assets are pegged to one index, and the floating rate liabilities are pegged to a different index, there can be issues if the indexes do move the exact amount.
Another type of swap is a fixed-for-fixed swap. When you have a fixed-for-fixed swap, the country, financial institution, or company will agree to pay each other a fixed interest rate related to the principal amount. These swaps are typically used and can be leveraged off when interest rates in one country are lower than in another.
What are swap lines, and who transacts them?
The Federal Reserve has established central bank swap lines to help support the global economy. Swap lines were first leveraged during the financial crisis of 2008.
After the financial market crisis, these types of swaps were broadened to numerous counties worldwide.
When the currency swap occurs, the Fed, in conjunction with a foreign bank, will exchange currency of equal value. The two banks involved in the swap will exchange currency of the same value over a specified period.
The Federal Reserve supplies United States dollars and will, in turn, receive an equivalent value of a foreign currency. When the transaction initially takes place, a market-based exchange rate is calculated and applied when the contract or swap expires.
Also, it is essential to note that the Federal Reserve receives back the same amount of money it initially provided the foreign bank, and there is no foreign exchange risk.
Conclusion
Japan and South Korea have not had the most remarkable diplomatic partnership during the last few decades. However, they recently agreed to swap 10 billion dollars of currency when needed. The agreement for the currency swap was not due to an immediate need for either country but more so to stimulate economic exchanges between the two countries.
With the new agreement in place, Japan and South Korea will have the option of exchanging their currencies when needed, usually during an economic crisis. The new deal is over three years.
There are several different types of currency swaps. A fixed-for-floating currency swap is when two parties swap interest cash flows from fixed-rate loans for floating-rate loans. This swap is utilized because the swap reduces the interest expense through the process of swapping for a floating rate if the floating rate is lower than that of the fixed rate.
The second type of swap is the fixed-for-fixed swap. This type of swap allows the parties involved to pay each other a fixed interest rate on the principal amount.
The last type of swap is a basis swap. With this type of swap, the parties exchange two floating rates. The basis swap exists because it allows the entity to reduce its basis risk. Basis risk is typically what happens when you have cash flows that are affected by circumstances that are not correlated.
Swaps are a very valuable financial tool that continues to be leveraged throughout the globe. A currency swap is a contract between two entities that agree to swap a specified amount of currency over a specified period of time.
Currency swaps are used to reduce currency risk and lower financing costs. In addition, currency swaps can be used to access another country's currency. To execute a currency swap, you need to find another party looking to exchange currencies. This could be another country/government, financial institution, or company. Once you find your counterparty, you will agree to the terms of the swap, such as the amount of the currency to be exchanged, the length of the contract, and the interest rates to be paid.
Once the agreements are ironed out, the two parties exchange currencies and then make interest payments. When the swap is over, the two parties then exchange the currencies back to one another.
Currency swaps can be beneficial; however, the entities involved with currency swaps should consider the risks associated with currency swaps. These are counterparty risks in that the other party could default on their obligation, thus exposing either side to losses.
Interest rate risk can be a real problem with currency swaps. If interest rates are to change, either party could end up paying more interest than they bargained for. And the last type of risk associated with currency swaps is exchange rate risk. If the exchange rate changes, either party could lose money on the swap.