Currency swaps can be confusing

MYSTERY POST: So we have a second look

We touched upon currency swaps in my last post about how IndusInd Bank messed up its accounting and exaggerated its profits. This post isn’t about IndusInd, it’s about currency swaps. They’re confusing so let’s look at them independently for just a moment.

You have some money in one currency, but you do business in another currency. You want to remain immune to random exchange rate fluctuations. If you’re able to find someone who wants to do what you want to do, but with the currencies in reverse, you can both just mooch off each other.

Let’s go back to the example from my last post:

1. You’ve borrowed $10 million from the US. You need dollars to pay the lender interest. But you need rupees to do your business in India.

2. You swap the $10 mil for ₹86 crore with someone. You now have the rupees you needed to do business.

3. This is effectively you borrowing ₹86 crore from him, and him borrowing $10 million from you.

4. So you both pay interest to each other on these borrowed amounts. The interest rates are fixed, there are no surprises.¹

5. He’s borrowed dollars, so he pays you interest in dollars! You now how dollars to pass on to your US lender. You’ve borrowed rupees and pay interest in rupees.

6. At the end of it all, you re-swap (un-swap?) your dollars and rupees.

A question that pops up is why would this other party borrow $10 million from you instead of borrowing directly from the US market? One reason is that you’re a bank borrowing a large amount of money. Your counterparty could be a smaller business not having the same kind of access because they’re small and less reliable. The interest rate they get from you could be better than what they get directly.

Another reason could be that they’re a hedge fund looking to bet on the other side of the trade.