What is currency exchange?

Swap is a term, which in English means “exchange” or “exchange”, used as a reference for contracts that allow the exchange of indices between two parties.

In a floating exchange rate regime, as in Brazil, several agents incur exchange risk when they need to change from one currency to another, at a future date, the amount necessary for their transactions.

Because of this, investors and entrepreneurs may enter into an exchange contract to exchange an index for exchange rate variation at a future date.

These types of contracts, which come from the Central Bank, are known as currency swaps and provide future protection for those who need to face the unpredictable currency market.

How the Central Bank currency exchange works

For the Central Bank of Brazil, the currency swap is a financial instrument that helps in the process of intervention in exchange rates, to contain its volatility.

This operation is carried out between the Central Bank and other banks in the country, which are passed on to investors interested in exchanging a profitability index, for the variation of the foreign currency. This is the case, for example, of an agent with an investment remunerated at a DI rate, who exchanges his earnings for the uncertain variation of the dollar, in an agreed period.

The currency exchange works as a kind of “bet”, since the investor who hires it exchanges all the profitability of its investment for the variation of the exchange rate in the period, which may not be as high.

Therefore, in the final period, the investor receives the amount in foreign currency and delivers the return on his investment, plus fees, which are intended for the Central Bank. For the BC, this operation causes fewer investors to enter the spot market, reducing the exchange rate for the period.

Reverse currency exchange

The transaction described above is known as the traditional currency exchange, since the intention of the Central Bank is to keep the exchange rate low by “withdrawing” investors from the cash market.

Otherwise,  the operation is known as reverse currency exchange when the intention is that the exchange rate increases  , after the Central Bank understands that it is reduced to the level of the country’s economy.

In this case, the operation consists of reversing the “traditional” contracts, paying the changes in the interest rate to the investors and acquiring the changes in the exchange rate of these agents.

Through the traditional operation, investors who purchase currency swaps no longer participate in the spot market, which reduces the demand for currency and causes a reduction in exchange rates.

In reverse operation, the effect is the opposite, as it induces investors to seek foreign currency, causing the exchange rate to rise again.

Currency exchange example

As an example, we consider a company that has an investment with a return of 100% of the CDI, which matures in 45 days, with the following characteristics:

  • Investment: R $ 500,000.00
  • 45-day CDI: 1.34%
  • Profitability after 45 days: 500,000 x 1.34% = R $ 506,700.00

With this amount, the company intends to transfer to the United States, making the exchange for dollars, after these 45 days. However, the exchange rate may increase further, making the US dollar more “expensive” for the company.

To avoid this risk, the company makes an exchange with a bank, which assumes the exchange risk, paying the difference in the exchange rate in this 45-day period.

After this period, what the company does is deliver the R $ 506,700.00 to the bank, in exchange for the variation in the dollar exchange rate.

If we consider that at the time of the contract the exchange rate was R $ 3.26 to one dollar, the value of R $ 500,000.00 could be changed to $ 153,374.23 (500,000 ÷ 3.26), but instead, there was a currency exchange between the variation in dollars guaranteed by the bank and the performance of the CDI by the company.

Thus, after 45 days, at the end of the contract, the scenario was that the dollar rose to R $ 3.31 per dollar, that is:

  • Variation in dollars of 1.5%
  • The company delivers R $ 506,700 to the bank
  • In exchange, he receives R $ 507,500.00 (500,000 x 1.5%).

For the company, the risk with the exchange rate variation was canceled by a hedging operation, that is, by a risk hedging operation, and the bank reimbursed the difference.

If the exchange rate had been lower than the CDI yield, such as 1.2%, for example, the company ends up returning a larger amount to the bank. However, since the intention would be to convert the amount into dollars, the coverage occurs in the same way.