The Role of Currency Swaps in the Foreign Exchange Market:

1.2.2.2. Interest rate risk:

Interest rate risk is a type of risk that occurs when there is a change in market interest rates or factors related to interest rates, leading to loss of assets or reduction in investor profits .

In particular, commercial banks - the largest participants in the foreign exchange market - are the ones most exposed to interest rate risk. Interest rate risk occurs when there is a mismatch between the assets and liabilities of the bank, increasing the cost of capital, reducing income from assets, and reducing the market value of the assets and equity of the bank. In general, the consequences of interest rate risk on the bank's operations are very large. Therefore, banks must always come up with effective risk prevention measures.

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1.2.3. Speculation in the foreign exchange market:

Speculators in the foreign exchange market are those who are willing to take risks in foreign exchange transactions in order to receive larger profits. They try to anticipate market trends and make profits by creating positions (sell or buy) in foreign currencies. For example, companies that conduct commercial transactions that incur foreign exchange risks without hedging foreign exchange risks, or individuals who buy stocks, bonds or assets denominated in foreign currencies without hedging foreign exchange risks... all of the above cases can earn foreign exchange profits or suffer foreign exchange losses when foreign exchange rates fluctuate. Therefore, it can be said that the above transactions are all speculative.

There are two forms of foreign exchange speculation: i) When expecting a currency to appreciate, speculators will apply the principle of " buy low, sell high ", that is, buy at the exchange rate

3 As defined on http://www.investopedia.com/terms/i/interestraterisk.asp

ii) when expecting a currency to depreciate, speculators will “ short sell ” or “ sell first, deliver later ”. In general, speculators are risk lovers and bet on those risks to make a profit.

The term “ speculative activity ” evokes negative associations for many people. The speculative sector in the foreign exchange market is very large and can cause significant fluctuations in exchange rates, causing harm to the global economy in general. In fact, there are periods when speculators dominate the market, contributing to the economic crisis of a country such as the currency crisis in Thailand or Indonesia in 1997. However, according to some experts, the speculative element is necessary for the market because thanks to it, the foreign exchange market has high liquidity to handle non-speculative transactions. Without the speculative element, the difference between the buying and selling exchange rates is very large, the transaction speed is slow and large transactions are difficult. Therefore, although the speculative element may have negative implications, it is one of the main driving forces that create conditions for the foreign exchange market to operate effectively.

2. Currency swap:

A currency swap is an agreement between two parties to exchange two cash flows of two different currencies at a specified future date at a predetermined exchange rate 4 .

Along with the development of the foreign exchange market, currency swaps also have many different types, suitable for each need and purpose of use of market participants. However, the thesis will only mention the three basic and most typical types of currency swap contracts: foreign exchange swaps

4 As defined on http://www.investopedia.com/terms/c/currencyswap.asp

( forex swap), back-to-back loan , cross currency swap .

2.1. Foreign exchange swap:

A foreign exchange swap is the exchange of two currencies through two sides of the transaction executed at two different value dates 5 .

In which a currency is bought/sold at the present time and sold/bought back in the future. This is a type of foreign exchange swap contract called “ Spot – Forward Swap ”. Or a currency is bought/sold at a time in the future and sold/bought back at another date in the future. This is a type of foreign exchange swap contract called “Forward – Forward swap ”. Because “Forward – Forward” swap transactions are rarely used, this thesis will only mention and analyze “Spot” foreign exchange swap transactions.

– term”.

For example, a forex trader has EUR 500,000 but needs USD 450,000 in the next three months. To avoid exchange rate risk, the forex trader enters into a foreign exchange swap with the bank. At the present time, the forex trader will exchange EUR 500,000 for USD 450,000 at the agreed rate of 0.90. After three months, at the agreed forward rate of 0.8955, the forex trader will pay the bank USD 447,750 and receive EUR 500,000.

Forex swaps have the following characteristics:

 The quantity of two currencies bought and sold is fixed.

5 According to the definition on http://financial-dictionary.thefreedictionary.com/Foreign+Exchange+Swap

 Foreign exchange swaps consist of two sides: spot and forward, so the contract applies two exchange rates: spot rate and forward rate.

In which, the forward rate is calculated approximately according to the following formula:

F= S + S.(Rt – Rc).T

F: forward rate

S: spot rate

Rt: interest rate of the quoted currency Rc: interest rate of the quoted currency T: contract term

 During the term of the contract (from the transaction date of side 1 to the transaction date of side 2), no cash flows occur except for the two cash flows that occur when executing the spot side and the forward side. This means that the interest accrued during the contract term is paid in one lump sum at the time the contract expires.

 The term of the contract is usually short.

 Foreign exchange swap transactions do not create a net foreign exchange position, so exchange rate risk is avoided.

 Foreign exchange swaps create timing mismatches in cash flows. Therefore, the parties to the contract are still exposed to interest rate risk.

 Foreign exchange swaps are a flexible and convenient instrument, traded permanently and popularly in the OTC market. Thanks to foreign exchange swaps, traders in the foreign exchange market can temporarily convert one currency into another without fear of being affected by exchange rate fluctuations when in a sell/buy position. Foreign exchange swaps are widely used by traders for liquidity management, risk hedging, speculation, and other purposes.

2.2. Back-to-back credit:

Back-to-back loan ( or parallel loan ) is a loan contract in which two companies lend each other a certain amount of money in their own currency at a pre-agreed interest rate. And after the contract expires, the two companies will repay the loan together, ending the back-to-back credit contract. The purpose of back-to-back credit is to hedge against risks from exchange rate fluctuations.

Company A

Can easily borrow or have excess X currency

Company B

Can easily borrow or have excess Y currency

Lend currency X from company A

Lend Y currency

from company B

For example, an American company enters into a back-to-back credit agreement with a Mexican company. The American company will borrow pesos from the Mexican company, while the Mexican company will borrow dollars from the American company.

Some features of back-to-back credit:

 There are two currencies involved (currency A and currency B)

 There are two types of pre-agreed interest rates (fixed interest rate or floating interest rate)

 There is an actual exchange of two principal amounts (this is the difference with an interest rate swap) and interest.

 The interest cash flow generated is not calculated as net interest before being paid to the counterparty because this interest cash flow is calculated in two different currencies.

Back-to-back credit has three basic forms:

Fixed for floating rate , different currencies – Plain vanilla swaps :

Party X will pay/receive the principal and interest calculated at the fixed interest rate of currency A to receive/repay the principal and interest calculated at the floating interest rate of currency B.

For example, Party X will pay a fixed interest of 5.32% on a principal of USD 10 million to receive a 3-month TIBOR floating interest rate on a principal of JPY 1.2 billion (the exchange rate at the time of entering into the swap contract is USD/JPY 120).

Floating for floating rate, different currencies :

Party X will pay/receive the principal and interest calculated at the floating interest rate of currency A to receive/repay the principal and interest calculated at the floating interest rate of currency B.

For example, Party X will pay 1-month LIBOR floating interest on a principal of USD 10 million to receive 3-month TIBOR floating interest on a principal of JPY 1.2 billion (the exchange rate at the time of entering into the swap contract is USD/JPY 120).

Fixed for fixed rate, different currencies:

Party X will pay/receive the principal and interest calculated at the fixed interest rate of currency A to receive/repay the principal and interest calculated at the fixed interest rate of currency B.

For example, Party X will pay a fixed interest rate of 5.36% on a principal of USD 10 million to receive a fixed interest rate of 1.6% on a principal of JPY 1.2 billion (the exchange rate at the time of entering into the swap contract is USD/JPY 120).

Back-to-back credit has been documented since the 18th century, but it only became widely used in the 19th and early 20th centuries. By using back-to-back credit, companies could avoid taxes on foreign investments and obtain the currency they needed in the foreign exchange market. In addition, the pre-fixed exchange rate ensured that no fluctuations in the value of the borrowed currency would cause the company to default on its debt. However, back-to-back credit is no longer popular today due to the emergence of a new type of currency swap – the cross-currency swap .

2.3. Cross currency swap:

Cross currency swap is developed based on back-to-back credit, so it has many characteristics of this type. Cross currency swap can be understood as an agreement between the parties to i) exchange two principal amounts calculated in two different currencies at the pre-agreed spot exchange rate, ii) exchange interest cash flows arising on the two principal amounts (one interest amount calculated at a fixed interest rate and the other at a floating interest rate), iii) re-exchange the principal amount at maturity at the originally agreed spot exchange rate . Sometimes the initial principal exchange does not need to be performed.

In a foreign exchange swap, only the principal amount is exchanged. But in a cross-currency swap, in addition to the principal amount, the interest that arises during the contract's validity period is also exchanged. A cross-currency swap has a similar mechanism to an interest rate swap. However, an interest rate swap only involves the exchange of interest cash flows, and only one currency is involved.

3. The role of currency swap contracts in the foreign exchange market:

International trade activities are increasingly developing in both breadth and depth, trade exchanges and cooperation are not only limited within the borders of a country but are on a global scale, economic transactions are increasing in both scale and value, the need to use foreign currency has become an indispensable part of international economic and financial life. However, trading in the foreign exchange market means that any investor must face risks, in which the most common risks are exchange rate risk and interest rate risk. In particular, 85% of the foreign exchange market turnover is in the interbank market, which means that commercial banks are the most active market participants and are also most influenced by the market. In addition to traditional banking operations, banks have constantly developed new and modern financial operations, including foreign exchange trading transactions. This is a business activity that can bring very high profits to commercial banks, but it is also full of risks. When participating in currency trading activities, banks will create open foreign currency positions and lead to exchange rate risks for banks if exchange rates or interest rates in the market fluctuate strongly. Because of the above characteristics, risk prevention is very necessary for banking activities in particular and business activities of members participating in the foreign exchange market in general.

Based on that objective need, foreign exchange derivative products have been born one after another with a great role in preventing exchange rate risks, on the one hand, they can ensure financial safety, on the other hand, they can conduct profitable business through these insurance tools. In which, currency swap transactions have increased the fastest in both turnover and proportion thanks to very practical applications and benefits in reality for investors, import-export traders and banks. Using currency swaps helps market participants effectively prevent exchange rate risks, interest rate risks,

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