This content explains how financial instruments called swaps can be used to manage foreign exchange (FX) risk, differentiating between Forex Swaps and Currency Swaps based on their objectives and mechanisms.
Mind Map
Click to expand
Click to explore the full interactive mind map • Zoom, pan, and navigate
We are still much on FX risk management
and remember we said to manage FX risk
usually you can be using internal method
or external method we've been looking at
external method for some time now things
like forward
money market edge futures
options the last video actually focused
on options
and now we're looking at swaps. So this
is done done.
Now we finish
FX risk management with swaps which is
quite short. So now I'm going to be
looking at swaps. How do we use swaps to
manage our FX risk exposure?
First of all you need to know there are
two types of this. Please take note and
they are totally different. The first
type is a forex swap
and the other one is a currency swap
and this differs based on the objective
that is what the company is trying to
mitigate the situation of the company.
Why would a company wants to use forex
exposure I mean forex swaps?
Usually this is necessary or comes handy
when the company is struggling to borrow
in foreign currency.
So this one is just for a company to
have I'll say for access to
to
borrowing borrowing foreign currency borrowing.
Yeah. Usually that the company will not
be able to get so let's say not
maybe because of credit rating or
because of restrictions or whatever it
is that is when a company most likely
will decide to use forex swap. However,
if the objective of the company is to
look for cheap foreign loan, you see
different thing. The access is there,
but definitely
it will be more expensive as a foreign
country company. Think about it. If you
are a company based in the UK and you
want to borrow money in Australia, your
rate will be different from an
Australian company that resides in
Australia that is trying to borrow
within Australia because there is a
inter jurisdiction and because of that
locationational international difference
then there's an additional risk that
will be attached to that borrower and
because of that your borrowing rate will
be different and in that case a currency
swap will help you in that space. So
this one is used to
swap interest rates.
I'm going to explain how this program
work. This is just a way to swap
interest rate in
in
Yeah. And what do you get? Most likely
what you're looking for is a cheaper boring
boring
This one is about cost
interest rates.
So that is the cost of loan.
Yeah. So I'm going to use example to
just drive this home quickly. This is
very easy. What we're saying here is
that you need two parties.
A needs the currency of B
and they go into swap agreement. They
fix rate
the swap money principle.
A gives B is currency. PP gives a
currency on day one
and expiring the swap back. That's all
we're saying.
B returns the money, A returns the
That's what we're saying. But it's
different for currency swap because for
currency swap
A will help B to take loan in his own
currency. So A will gives B
loan itself the loan amount.
Yeah. A will be paying the bank interest.
interest. Yeah.
Yeah.
However, B will have to refund A of that interest
interest
and the same thing A will be doing for
B. B will do for A. So B will also help
A to borrow money in his own currency.
B will be servicing the interest in his
country. However, A will have to refund
that money back to
B. So they are each other. So you can
see in currency both principle
and interest
are relevant.
But here our focus is just on principle swap
swap
just to make you see the difference
easily. Okay, take one second to digest
that. Now, let's look at the question
for both of them just to help you so
that you can have a better grasp of what
we're talking about. Look at this
question is on forex swap. I'm going to
be using this question to explain what
we've been talking about forex swap. You
have man that wants to go to Pakistan to
build a school. Usman is a UK company.
So which means Usman does not have rupes
but is lucky that the government of
Pakistan has agreed to swap
100 million for £5 million
because if you look at it the current
spot rate was the agree.
So first of all you need the swap rate
that has been agreed. This swap rate
will be used both at the beginning
and at the end such that the amount will
not be different. That's why they always
fix it. So in this question that rate
has been agreed to be 20 rupees for
So which means
we try to break it down. Let's say we
have Usman here
and uh
I'll just put government here but my
focus is on Usman which is the company
that is trying to use the edging method. Right
Right
what is going to happen? A one
Usman will have to borrow
in local currency because
because
he needs to 100 rupees in on day one and
20 rupees is one pound. So which means
the total amount that he will need to be
able to do his swap. He needs to swap
his in his own currency for what he
want. That will be equivalent to 5
million. Yeah, that is 100 million rupees.
rupees.
So if he's going to get 100 million
rupees from the government, he must be
able to give government 5 million
pounds. Government of Pakistan. But
remember, you don't use your money for
all these transactions because without
your money, you won't need all this edge
anyway. So you have to go and borrow
money. So he needs to borrow 5 million.
So he's going to borrow 5 million and
So which means it's going to leave 5
million and it's going to give it to
Likewise, government will have to let go
of so let's say we have two currency
column one for pounds and one for rupee.
Let's do the same thing here
for pounds and for rupee.
So same day government will also need to
let go of 100 million rupees and they
will give it to
Mr. Usman come who's trying to build a
school. So on day one you can see that
Usman already has the money that he
needs for his investment. And this
particularly is important because
remember that he doesn't have to buy
foreign currency at the expiry date
because he's doing this strategy because
he knows that he's going to get 100 200
million actually.
So from this he can actually pay back
the he can close the swap. Yeah. Without
necessary having to buy currency and
having more exposure.
So that is day one.
The swap already in existence.
No interest is paid. Next thing is you
wait to expire. So two years time two
things will happen.
Number one is that they need to close
the swap.
So which means they swap again.
Yeah. So what we are saying is
they reverse the initial swap. So which
means this time around
man will be the one that will receive
5 million pounds from the government and
he would have received his 200 million
from the sale of the school. Out of that
he will have to give the government 100
million rupee back. Government will also
pay him back this £5 million and they
receive their 100 million. You can see
this comes to zero for government. Our
focus is on this guy Usman. Remember it
doesn't end here for us man. There are
two things left.
The second one after the first one we
spoken about is the fact that he will
need to
Unfortunately for him on this date after
two years rupee has gone to 40 uh one
pound. So which means that 100
million rupee will now be worth just 2.5
million. You see that is lucky that you
actually edge. So
So
see more because he also borrowed
remember the 5 million was borrowed for
2 years and they gave us the interest
rates in the UK at 10%. So he's going to
pay interest at 10% for 2 years over the
amount of 5 million that he borrowed and
that means he's still going to pay an
extra one year.
So invariably you'll discover that he's
still better off. Rupee drops to zero
and his local currency say gives him
additional 1.5 million left.
That is
what Forex swap is all about. It's
pretty straightforward. You just
swapping at the beginning at the end at
the same fixed rate. And remember in the
middle you I mean at the end of the
of the contract you need to
find out how much interest expense the
company will pay because you will always
have to borrow your first swap. That's
the major thing. It's not the time
you're going to have excess but if you
have excess as well you need to know
that that will be done at the spot
trade. Excess is just like unhedged
portion. That is what we always say that
you need to know be careful because you
might always have unedged
portion of your exposure
and if it's on edge then it will have to
be executed at the market spot. Whatever
the market spot rate is talking about
that will be your reality.
Let's look at another question for
currency swap.
So that is for forex swap. Let's look at
currency swap.
So you can take one minute to look at
this question. Very interesting one.
This is on currency swap. Remember what
I said. Currency swap is a way to look
for deep foreign loan.
And if you had read this scenario that I
have here, you'll discover that if one
is trying to go to Euro by himself to
borrow, he will have to borrow at 5.6.
But if Eurosport helps him to borrow,
he'll be able to get the same loan at
5.5. Same thing applicable to Eurosport.
If Eurosport decides to go and borrow by
himself in Australia, he will have to
pay at 7.2%. 2%.
However, if he's smart enough to use
currency swap, one can actually borrow
for him at 7%. Much cheaper. Now, let's
look at the dynamics. How does this work
for the two companies? How do they set
this up? Remember
initiation this is a swap
and at initation said both principle
will be swapped as well. It's not just
interest it's not just principle in this
currency swap both principal and
interest are swapped. And how does it
work? What will happen?
Let's break this into two sections.
Yeah. So, now we're talking of
initation. What is going to happen on
day one? That's what we're saying
a one
because one will have to help
zero spot zero spot will have to one.
But what we know is that what one needs
this guy needs
Erosport needs
He doesn't want to go to Australia to
get it because of the rate will be 7.2%.
This guy too doesn't want to go to
Europe to get it himself because if he
tries to do that, you will need to pay
at 5.6%.
Now they approached each other and they
agreed to do a foreign currency swap.
swap.
Okay. What does this mean for both of
them? On day one means that one
one co will have to borrow. So this guy borrows
on behalf of Eurosport. He doesn't have
to tell the bank that he's borrowing for
EOS. just get it himself. So he borrows that
that
the same thing will do trying to help
his brother
have to borrow what one needs
to form. Can see they've helped each
other to borrow.
Once they borrow it, they swap. So the
swap starts immediately on day one which means
means one
one gives
gives
euro spot
the money we borrow from him 40 million
and return
he will receive
24 million euro from
from
Similarly, you have the same thing going
on on the other side because
Euro sport. Yes.
Euro sport.
We have to hand over this money to one
gives 24 million euro
to one co.
Yeah, that's this and
and
the money that he has been praying for
Yeah, I'm talking about Euro sport here.
Confusible currency.
Okay, you can see that is the swap on
the one that's happened. This goes to
they have to be servicing the loan.
Yeah, you pay interest the loan you have
collected because the bank does not know
that when has collected loan for
anybody. So when we have to pay
interest. So which means let's said this
is for one year we have assigned the
yeah assume the interest is paid end of
the year. Yeah that's going to be the
case anyway
you simplify the scenario. Okay
remember what is to get the understanding.
understanding.
So after one year
one will have to pay interest for sure.
So which means but you'll be paying that
interest at 7%.
Yeah. Likewise your spot will pay
interest on euro loan but 5.5%.
5.5%.
Mr. one
at 7%.
And that will be equivalent to just
We have to pay his own back to
the interest on the looney collected
That's equivalent to
just 1.32
Then the next thing again is swap the interest.
interest.
So this follow this followed by interest swap.
Remember initially swap the principle
What is going to happen?
You can already know because
it's a refund session which means that one
one
will have to refund your spot. So one pays
pays
just€1.32 million.
million.
So that's a refund for this
Yeah, use different color as a refund.
It's trying to refund him of this. Likewise,
Likewise,
your spot will have to refund one as
the same swap will happen here. And
that amount that he paid on his behalf
and that is 2.8 million Australian dollars
dollars
you have swapped. You will discover that
invariably what you are saying is that
this guy has been compensated for this.
He got a refund through this. Likewise,
this guy
has been compensated for this because he got
got
a refund.
So invariably what we're saying is that
the net interest
that these guys have paid is that this
guy has paid 1.32 million interest and
this guy has paid
2.8 million
Australian dollars. And imagine
if they had not done this, this guy
Yeah. But let me finish before I show
you that so that you don't confuse it.
Let's just finish. So interesting.
interesting.
We're done with the interest swap. But
they cannot close it because it's also
needing to still swap the principle to
close to fully close the contract.
So principal is swap both at the
beginning and at the end. Yeah.
So principal swap.
Yeah. To close,
not to initiate. Remember they do to
initiate and they also do to close. So
in that case it means that Euro sport
will have to give one the money that he
hand over handed over to him at the
beginning. So and one will do the same
thing. So one gives
gives
Euro spot
the principle which is 24 million.
the $40 million Australian dollars that
he borrowed for him.
And once that is done,
one can now cuz this money is coming to
one. So one will
Yeah. Likewise, your sport can repay the back
and the opening is closed. So, Europe
spot will repay the bank is 24 million
and one will repay the bank the 40
million Australian dollars
and that is it. That is currency as
well. And like I was saying, look at how
much they paid. Let's see without edge,
without edging? It means that that 24
million that he borrowed, he would have
And that would have been
equals to 1.344.
1.344 million.
That's what you would have paid instead
And the other guy would have paid at 7.2%
of 40 million Australian dollars which
would have been
2.88 88
savings easy we can see it that is
equals to 1.344
minus 1.32
and this guy the same as we're having
which means this guy was able to save
and this guy was able to save
$80,000 Australian dollars.
That's how much they are able to save by
edging. So that is it basic understanding
understanding
very good straightforward
and that actually marks the end of
FX risk management
the next series we'll start looking at
interest rate management and the same
strategy we're going to be using going
to be talking about forward future
future
options and swaps. But this time around
Click on any text or timestamp to jump to that moment in the video
Share:
Most transcripts ready in under 5 seconds
One-Click Copy125+ LanguagesSearch ContentJump to Timestamps
Paste YouTube URL
Enter any YouTube video link to get the full transcript
Transcript Extraction Form
Most transcripts ready in under 5 seconds
Get Our Chrome Extension
Get transcripts instantly without leaving YouTube. Install our Chrome extension for one-click access to any video's transcript directly on the watch page.
