This is part 3 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 and 2, we discussed the beginnings of swaps as well as the differences between interest rate swaps and currency swaps. In part 3, we’ll discuss fixed-for-floating swaps.
But before we jump into some math, we should reestablish the basic motivation behind swaps: comparable advantage. For example, if the party (party A) holding the floating rate instrument believes rates will increase in the short-term while the party (party B) holding the fixed rate instrument believes rates will decrease in the short-term, they might swap obligations. Thus, once the swap is complete, party A is ‘long the fixed rate, short the floating rate,’ while party B is ‘short the fixed rate, long the floating rate.’
The aforementioned example is a plain vanilla swap, a fixed-for-floating swap involving only one currency (i.e. a swap agreement involving two companies using the same domestic currency). Let’s say party A wants to take out a loan, at 12% and a floating rate of LIBOR +2% (but would really prefer a fixed rate). Conversely, party B wants to take out a loan, at 8% and a fixed rate of LIBOR +4% (but would really prefer a floating rate). By using a fixed-for-floating swap, both party A and party B can exchange obligations and receive their respective desired interest rates.
While fixed-for-floating swaps involving one currency are simple, they become slightly more complicated when involving more than one currency. As the name suggests, fixed-for-floating swaps in different currencies involve exchanging a fixed rate in one currency (i.e. U.S. Dollars) for a floating rate in another currency (i.e. Euros).
For example, if a company A has a fixed rate $50 million loan at 6.5% paid monthly and a floating rate investment of €75 billion that yields EUR 1M LIBOR +75-basis points monthly, and is worried about exchange rate fluctuations, it may choose to enter a fixed-for-floating currency swap with another firm, company B. In this example, company A wants to ensure profit in U.S. Dollars as they expect one of two things to occur: either the EURUSD exchange rate to drop; or the EUR 1M LIBOR to drop. By entering a fixed-for-floating currency swap with company B, paying EUR 1M LIBOR +75-basis points and receiving a 7.0% fixed rate, company A secures 50-basis points of profit and reduces its interest rate exposure.
In part 4 of 10 of this series, we’ll discuss floating-for-floating and fixed-for-fixed swaps.