Key Takeaways
- A fixed-for-fixed currency swap involves exchanging fixed interest payments in one currency for fixed interest payments in another.
- This type of swap is utilized to gain more favorable loan terms than available in the foreign capital markets.
- Counterparties agree to pay each other a fixed interest rate without exchanging the principal amount.
- Fixed-for-fixed swaps differ from fixed-for-floating swaps, where one party pays a fluctuating interest rate.
- These swaps can leverage comparative advantages between countries with different interest rates for cost savings.
What Is a Fixed-for-Fixed Swap?
A fixed-for-fixed swap is a type of foreign currency derivative where two parties agree to exchange fixed interest payments in one currency for those in another currency. These swaps are primarily used to manage currency risk and to take advantage of favorable interest rates in different countries.
Here we’ll explain how fixed-for-fixed swaps work, the benefits they offer, how they differ from fixed-for-floating swaps, and how these financial instruments can benefit entities looking to optimize their financing strategies.
How Fixed-for-Fixed Swaps Work
Currency swaps take place between two foreign entities. The parties essentially swap principal and interest payments on a loan in one currency for those in another currency. One of the parties involved in the agreement borrows currency from another while lending a different currency to that party. Foreign currency swaps come in fixed-for-floating and fixed-for-fixed swaps.
The parties involved in a fixed-for-fixed swap—who are also called counterparties—enter into an agreement, paying each other interest at a fixed rate. So one party agrees to exchange fixed interest payments in one currency for interest at a fixed rate in another. This means one party uses its own currency to buy funds in the foreign currency.
Foreign currency swaps—including fixed-for-fixed swaps—allow entities to get loans at better interest rates than if they were to go directly for financing in the foreign capital markets.
Important
In fixed-for-fixed swaps, one party uses its own currency to buy funds in the other party’s currency.
Benefits of Fixed-for-Fixed Swaps
To understand how investors benefit from these types of arrangements, consider a situation in which each party has a comparative advantage to take out a loan at a certain rate and currency. For example, an American firm can take out a loan in the United States at a 7% interest rate, but requires a loan in yen to finance an expansion project in Japan, where the interest rate is 10%. At the same time, a Japanese firm wishes to finance an expansion project in the U.S., but the interest rate is 12%, compared to the 9% interest rate in Japan.
Each party can benefit from the other’s interest rate through a fixed-for-fixed currency swap. In this case, the U.S. firm can borrow U.S. dollars for 7%, then lend the funds to the Japanese firm at 7%. The Japanese firm can borrow Japanese yen at 9%, then lend the funds to the U.S. firm for the same amount.
Fixed-for-Fixed vs. Fixed-for-Floating Swaps
As noted above, there are two primary kinds of currency swaps—fixed-for-fixed and fixed-for-floating swaps. Fixed-for-floating swaps involve two parties where one swaps interest on a loan at a fixed rate, while the other one pays interest at a floating rate. Unlike the fixed-for-fixed swap, the principal portion on the fixed-for-floating swap is not exchanged. One of the main reasons parties enter into this agreement if the floating interest rate is lower than the fixed rate that’s being paid.
