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A foreign currency swap is an agreement between two foreign parties to swap interest payments on a loan made in one currency for interest payments on a loan made in another currency. A foreign currency swap can involve exchanging principal, as well. This would be exchanged back when the agreement ends. Usually, though, a swap involves notional principal that's just used to calculate interest and isn't actually exchanged.
Key Takeaways A foreign currency swap is an agreement between two parties to swap interest rate payments on their respective loans in their different currencies. The agreement can also involve swapping principal amounts of loans. The two main types of swaps are fixed-for-fixed rate swaps and fixed-for-floating rate swaps. Foreign currency swaps can help companies borrow at a rate that's less expensive than that available from local financial institutions.
They can also be used to hedge or protect the value of an existing investment against the risk of exchange rate fluctuations. Understanding Foreign Currency Swaps One purpose of engaging in a currency swap is to procure loans in foreign currency at more favorable interest rates than might be available borrowing directly in a foreign market. During the financial crisis in , the Federal Reserve allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes.
In a transaction arranged by investment banking firm, Salomon Brothers, the World Bank entered into the very first currency swap in with IBM. Foreign currency swaps can be arranged for loans with maturities as long as 10 years. Currency swaps differ from interest rate swaps in that they can also involve principal exchanges. The Process of a Foreign Currency Swap In a foreign currency swap, each party to the agreement pays interest on the the other's loan principal amounts throughout the length of the agreement.
When the swap is over, if principal amounts were exchanged, they are exchanged once more at the agreed upon rate which would avoid transaction risk or the spot rate. LIBOR is the average interest rate that international banks use when borrowing from one another.
It has been used as a benchmark for other international borrowers. In fact, as of the end of , no new transactions in U. Types of Swaps There are two main types of currency swaps. The fixed-for-fixed rate currency swap involves exchanging fixed interest payments in one currency for fixed interest payments in another.
In the fixed-for-floating rate swap, fixed interest payments in one currency are exchanged for floating interest payments in another. In this type of swap, the principal amount of the underlying loan is not exchanged. Foreign currency swaps are a way of getting capital where it needs to go so that economic activity can thrive. The authors also develop longevity derivatives and annuities including variable annuities with guaranteed lifetime withdrawal benefit GLWB and inflation-indexed annuities.
Improved market and mortality models are developed and estimated using South African data to model the underlying risks. Macroeconomic variables dependence is modeled using a cointegrating VECM as used in Ngai and Sherris , which enables both short-run dependence and long-run equilibrium. Longevity swaps provide protection against longevity risk and benefit the most from hedging longevity risk. Longevity bonds are also effective as a hedging instrument in life annuities.
The cost of hedging, as reflected in the price of longevity risk, has a statistically significant effect on the effectiveness of hedging options. This study shows that to provide inflation-indexed life annuities, there is a need for an active market for hedging inflation in South Africa.
This would demand the South African Government through the help of Actuarial Society of South Africa ASSA to issue inflation-indexed securities which will help annuities and insurance providers immunize their portfolios from longevity risk. Social implications In South Africa, there is an infant market for inflation hedging and no market for longevity swaps.
The effect of not being able to hedge inflation is guaranteed, and longevity swaps in annuity products is revealed to be useful and significant, particularly using developing or emerging economies as a laboratory. This study has shown that government issuance or allowing issuance, of longevity swaps, can enable insurers to manage longevity risk. If the South African Government, through ASSA, is to develop a projected mortality reference index for South Africa, this would allow the development of mortality-linked securities and longevity swaps which ultimately maximize the social welfare of life assurance policy holders.