Currency swap is arrangement between two parties (customers) to exchange their obligations (payments) in different foreign currencies. Currency swap is not suitable for supplier seeking to hedge expected receipts.
Parties to the currency swap are still legally responsible for payment to their respective suppliers. In the event of default by any one party, other party will remain liable to its supplier.
It is the agreement between borrowers; lenders are not involved in currency swap.
Currency swap results in savings in transaction cost of Hedging. However, if an intermediary such as bank is involved in the arrangement of currency swap than organization will have to pay commission to the intermediary.
For currency swap to be effective following three conditions should be met.
- Payment of equal amount is required.
- Timing of payment should be same.
- Foreign currency to be paid should be home currency of other party.
It is difficult to find another organization that is facing the exactly same situation. Therefore, currency swap may not result in 100% effective hedge.
Currency swap can provide longer-term hedge than forward contract and future contract.
