What is a double currency exchange?
A dual currency swap is a type of derivative transaction that allows investors to hedge the currency risks associated with dual currency bonds. A dual currency bond is a kind of debt instrument where the coupon payment is denominated in one currency and the principal amount in another, which can expose the holder to currency risk.
A dual currency swap involves agreeing in advance to swap the principal or interest on dual currency bonds for a particular currency at predetermined exchange rates.
Dual currency swaps can help companies issue dual currency bonds by making them less exposed to the risks associated with paying in foreign currencies. Likewise, from the point of view of the bond investor, double currency swaps can reduce the risk of purchasing bonds denominated in foreign currencies.
Key points to remember
- A double currency swap is a derivative transaction that allows the parties involved to reduce their exposure to currency risk.
- It is commonly used in addition to dual currency bond transactions.
- Dual currency swaps involve the exchange of the principal and interest repayment obligations associated with a dual currency bond. The timing and terms of the dual currency swap would be structured to offset or hedge the currency risk of the bond.
Understanding Double Currency Swaps
The purpose of a double currency swap is to make it easier to buy and sell bonds denominated in different currencies. A company, for example, could benefit from making its bonds available to foreign investors in order to access a larger pool of capital or take advantage of better conditions. On the other hand, investors might find the bonds of a foreign company more attractive than those available in their home country. To meet this market demand, companies and investors can use dual currency bonds, which are a type of bond in which interest and principal payments are made in two different currencies.
While dual currency bonds can make it easier for companies and investors to buy and sell bonds internationally, they come with their own risks. Not only do these investors need to be concerned with the usual risks of bond investing, such as the creditworthiness of the issuer, but they also need to transact in a foreign currency whose value could fluctuate to their detriment during the term of the bond. obligation.
Double currency swaps are a type of derivative product in which the buyer and seller of a dual currency bond agree in advance to pay the principal and interest on the bond in a particular currency at rates of predetermined changes. This flexibility comes at a cost, which is the price, or premium, of the swap agreement.
Dual currency bonds can make it easier for investors and businesses to buy and sell bonds internationally.
Example of double currency exchange
Eurocorp is a European company that wants to borrow US $ 50 million to build a factory in the United States. Meanwhile, Americorp, an American company, wants to borrow US $ 50 million to build a factory in Europe.
These two companies issue bonds in order to raise the capital they need. They then set up a double currency swap between them, in order to reduce their respective currency risks. Under the dual currency swap, Eurocorp and Americorp exchange the obligations to repay the principal and interest rates associated with their bond issues. In addition, they agree in advance to use particular exchange rates, so that they are less exposed to potentially adverse movements in the forex market. It is important to note that the swap agreement is structured so that its maturity date coincides with the maturity date of the bonds of both companies.
Under their swap agreement, Eurocorp remits US $ 50 million to Americorp and receives an equivalent amount of euros in return. Eurocorp then pays interest denominated in euros to Americorp and receives an equivalent amount of interest denominated in USD.
As a result of this transaction, Eurocorp is able to serve the interest payments on their initial bond issue using the USD interest payments they receive from their swap agreement with Americorp. Likewise, Americorp may serve its bond interest payments using euros received from its swap agreement with Eurocorp.
Once the maturity date of the corporate bonds comes due, they cancel the exchange of principal that occurred at the start of their swap agreement and return that principal to their bond investors. In the end, the two companies benefited from the swap agreement because it enabled them to reduce their exposure to currency risk.