Currency Swaps

Currency swaps have been getting some attention recently in relation to Greece entering such agreements to conceal the extent of its budget deficit.

In its simplest form, a currency swap is an over-the-counter derivative in which two parties agree to exchange streams of interest payments in different currencies. A country or corporation typically enters into a currency swap when they borrow money in foreign currency and are concerned about foreign exchange fluctuations.

For example, if a country like Greece borrows dollars in the U.S., then they have to repay that debt in dollars. If the dollar strengthens against the euro, then Greece’s debt burden would increase. As a result, Greece might prefer to repay the debt in Euros, and currency swaps are an easy way to do that.

In a plain vanilla swap, two parties exchange principal amounts at the beginning of the swap – the principal amounts are set so as to be approximately equal to one another given the exchange rate at the time the swap is initiated. Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. At the end of the swap agreement, the parties re-exchange the original principal amounts – the principal payments are unaffected by exchange rates.

Greece’s swaps were not the plain vanilla kind that are designed to help manage debt, but instead were customized swaps designed to generate cash. In this instance, one party agrees to exchange money up front in return for higher payouts in the future. This sounds an awful lot like a loan, right? Yet these currency swaps are not accounted for as loans on the books of the national government.

It’s pretty easy to understand investors’ fears considering Greece has been hiding huge long-term liabilities from creditors. It’s even scarier to think about all the other countries that may have potentially entered into similar contracts.

Peter J. Lazaroff, Investment Analyst