A currency swap (also called as FX swap) is a binding agreement between two parties to buy or sell a specific currency amount at a fixed exchange rate on specified date near term and resell or repurchase it at the agreed exchange rate on specific date in more distant future. The parties determine both exchange rates when entering into the transaction. In other words, a currency swap consists of two transactions, the first of which is usually a spot foreign exchange transaction and the second is a foreign exchange forward. In essence currency swap could be seen also as borrowing one currency against another for certain time period. Whereas in case of standard borrowing an interest payment is made then in case of currency swap the interest rate is reflected in the swap rate.
- The exchange rates for both the initial and following transaction in swap are known in advance
- Accounting profit/loss is possible
- No additional expenses: taxes, premiums, commissions
For whom is it useful?
Companies that need a certain currency for a short period
EXAMPLE. A company is short of USD in order to pay for goods, but it expects income in USD (the company exports to the CIS countries, imports from Asian countries). The company can make a currency swap for the period until the expected income in USD will arrive in order to effect a payment now. By doing the currency swap company avoids opening himself to the currency risk. Namely as an alternative he could just buy USD to his account via standard currency conversion and initiate the needed payment and later on as the sales income arrives, he could sell USD via currency conversion, but this would mean that in the meantime he has been open to the risk of currency rate fluctuations and might suffer loss due to the currency rate moves.
Companies that have a forward – in order to advance or postpone the transaction
EXAMPLE. A company calculated that it will need to purchase SEK at the beginning of March (3 March) and made a forward SEK purchase transaction. However, it turned out in February that the payment is due on 15 February – for this purpose it needs a currency swap, the first settlement date of which would be 15 February and the second date would be 3 March. In case of postponing a transaction, the first settlement date would be 3 March and the second date would be later.
How is a currency swap rate calculated?
A currency swap has two rates – the rate for the first part of the transaction and the rate for the second part of the transaction. The first part rate is usually the spot foreign exchange rate at the time of the transaction. The second part rate is calculated in the same way as a foreign exchange forward rate.
How to make a currency swap?
Before being able to do FX swap transactions:
- The Client needs to sign the Derivatives Master Agreement
- The bank needs to do customer assessment and grant limit to customer for FX derivatives
- In connection of the MIFID requirements Bank needs to evaluate the suitability of the products to the Client.
A currency option is the right to buy or sell certain amount of currency at specific rate on agreed date in the future. Whereas bought option is purely a right but not an obligation for the option buyer then for the option seller it is an obligation.
- Possibility to choose an exchange rate
- Buyer has an option whether or not to perform the transaction on the settlement date
- The option buyer is to pay a premium
- In order to avoid additional costs, a combination of options can be made, where there is no premium
For whom is it useful?
Companies participating in tender procedures
EXAMPLE. A company takes part in a tender procedure for contract work. Materials would be bought from Asian countries, they would be paid for in USD. As margins usually are not big in tender procedures, the USD rate fluctuation can determine whether a contract will be profitable. Thus, hedge against fluctuation guarantees profit. In case a bid is not successful, the company has a possibility to sell the option if the option has value or let the option expire worthless if it does not have any value left.
Companies for which it is important to assess the worst case scenario – having an option, the worst case is known in advance
Companies expecting to earn from foreign exchange rate fluctuations
EXAMPLE. A company thinks that SEK rate will grow, but a possibility of decrease cannot be excluded either. Then, in case of buying an option which gives the right to buy SEK the Client wins if SEK gets stronger. If SEK rate decreases, the Client’s loss is limited to the paid premium.
How is the option rate calculated?
Various models can be used for calculation of the option price. One of the most popular is Black-Scholes model.
Currency option price or premium is affected by the following factors:
- Spot foreign exchange rate in the market (Spot – S)
- Transaction performance rate (Strike – X)
- Foreign currency interest rate for a relevant period (P1)
- Base currency (EUR) interest rate (P2)
- Interest rate difference (P2-P1)
- Option term (time to settlement date) (T)
- Foreign exchange rate volatility (Volatility – V) (this indicator reflects the foreign exchange rate fluctuation amplitude in a relevant period in percent; however its calculation is somewhat more complicated)
The price of the option grows as:
- The difference between the transaction performance rate and the spot foreign exchange rate in the market, which is favourable for the option buyer, increases
- Volatility increases
- Transaction period increases
How to make a currency option?
Before being able to do FX option transactions:
- The Client needs to sign the Derivatives Master Agreement.
- The Bank needs to do customer assessment and grant limit to customer for FX derivatives (only if customer is selling option / in case of option purchases limit is not needed).
- In connection of the MIFID requirements Bank needs to evaluate the suitability of the products to the Client.
Market and Credit Risk Factors
Foreign exchange forward
Foreign exchange forwardWhen entering into a foreign exchange forward, one must understand that when the transaction settlement date comes, the transaction will have to be performed irrespective of the foreign exchange rate in the market at the time. It may happen that the rate in the market will be more favourable than the pre-agreed forward rate, however, in spite of that, one will have to settle the forward at the rate agreed when the transaction was made, in this way losing potential profit, which would have been earned if no forward had been made.
Currency SwapWhen entering into a currency swap, one must understand that when the transaction settlement dates come, one will have to settle according to foreign exchange rates agreed at the time of entry into the transaction. A currency swap does not create an additional currency risk, thus, in this respect, it is essentially different from foreign exchange forwards. But the rate of the second part of a currency swap cannot change during the effective term of the transaction, irrespective of changes in interest rates of both the currencies and the effect of this on calculation of the above.
If the Client buys an option, no limit is necessary – the Client pays a premium on the transaction entry date and has no other obligations. On the contrary, it acquires the right to choose whether or not to perform the transaction. Standard settlement by paying a premium in the market is 2 business days after the entry into the transaction; if at the time of entry into the transaction the Client does not have funds in its bank account and chooses to pay in more than 2 business days, the Client needs a forward limit. If the Client wishes to sell an option to the Bank, a limit is necessary, as the Client gets an obligation to perform the transaction, meanwhile the Bank buys the right to choose whether or not to perform the transaction.
Possible loss of a currency option buyer is limited to the paid premium, whereas potential loss of the option seller is unlimited. Having in mind that the Client usually is an option buyer, its possibility to earn from the transaction is unlimited, whereas potential loss will not be more than the paid premium. In spite of that, the Client must admit that if on the transaction performance date the rate in the market is more favourable and it is not necessary to perform the option, it will face the situation where the option is kind of unnecessary for it, but the premium is already paid and non-refundable. Thus, an option should be treated as a method of hedging, but not a speculation.
Follow the instructions of regulators
The European Market Infrastructure Regulation (EMIR) is Regulation (EC) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories, which stipulates settlement of derivative instruments via central counterparties and the obligation to inform the trade repositories thereof and the new procedures for the management of derivative instrument contracts.
The regulative changes resulting from EMIR have an impact on all counterparties within and outside the financial sector (except private persons) who operate on the market of derivative instruments. This is part of the global effort to increase the transparency of the market and to decrease operational and counterparty credit risks on the markets of derivative instruments.
EMIR contains three main additional requirements compared to the previous provisions:
- Risk management standards must be perfected. All transactions with derivative instruments must be reported to trade repositories
- Transactions with derivative instruments which meet the established criteria must be settled via central counterparties
All derivative trades must be reported to trade repositories from 12 February 2014. A trade repository is and entity that centrally collects details about derivative trades in a register to which financial regulators have access for supervision purposes.
The reporting obligation covers both over-the-counter (OTC) and exchange-traded derivative instruments. It is important to note that forward currency contracts are also covered by the reporting obligation set forth in EMIR.
The reporting obligation applies to all parties that are registered in an EU/EEA country (except private persons, central banks and some public bodies). Danske Bank also reports transactions on behalf of its clients if so agreed between the bank and the client. Danske Bank reports the transactions of its clients to DTCC GTR (the Depository Trust & Clearing Corporation – Global Trade Repository).
If the client has requested the reporting service and consents to the terms and conditions of the service, the client authorises Danske Bank to report transactions with derivative instruments made with the bank to the trade repository on its behalf. In order to do this the client must request an LEI (Legal Entity Identifier) and inform Danske Bank about this.
LEI (Legal Entity Identifier) is used globally to identify legal entities. It is a combination of 20 numbers and letters.
How to obtain an LEI?
- Choose an LEI provider. See section below.
- Register your details on the provider's website.
- Pay the charge for registration. The charge appears on the website of each individual LEI provider.
- The LEI provider approves your details.
- Please provide Danske Bank with your new LEI by sending it by email firstname.lastname@example.org.
- Renew your LEI every year.
Requesting a LEI is subject to a fee (approx. USD 120 or €100) and it can take up to a couple of weeks.
Overview of LEI providers
See a list of all LEI providers here.
There are no authorised issuers in Lithuania at present. As such, you will need to apply via the website of an issuer stated above by setting up a user profile and submitting the required data.
Frequently asked questions
What is an LEI?
LEI is short for Legal Entity Identifier and is a number that allows unique identification of investors across the EU. Everyone with a legal entity, such as a business with a CVR no., a sole proprietorship, an association or a foundation, must have an LEI from 2018 to be able to trade in securities or derivatives.
Why is an LEI necessary to be able to trade?
When it is possible to identify everyone trading in securities or derivatives in the EU, it is easier to monitor the market and prevent manipulation etc., and this makes the investment market more secure. If your business, association or foundation does not obtain an LEI by 3 January 2018 at the latest, it will no longer be possible for you to invest yourself or have Danske Bank invest on behalf of your business, association or foundation.
What happens if I do not buy an LEI by 3 January 2018 at the latest?
If you do not buy an LEI by 3 January 2018 at the latest, you may no longer trade in securities or derivatives.
Where do I buy an LEI and what does it cost?
It is easy to buy an LEI from any authorised provider, such as NordLEI at nordlei.org. An LEI costs about USD 120; EUR 100. Once you have bought the LEI, you must remember to renew it every year.
How does Danske Bank get my LEI?
Please provide Danske Bank with your new LEI by sending it by email email@example.com.
I already have an LEI for my business. Do I need to do anything?
No, you do not need to do anything. Just remember to renew your LEI every year.