Circus Swap

When investors start swapping interest rates and foreign currencies, it can become a real circus. But all this is done for a very good reason. Circus swaps are a great way to hedge both foreign currency and interest rates.

Here's how it works: a variable or floating rate loan in one currency is traded for a fixed rate loan in another currency, or vice versa. The circus part comes from the acronym: Combined Interest Rate and Currency Swap. Very clever. The floating interest rate is usually indexed to the popular London Interbank Offered Rate (LIBOR).

In addition to the two parties doing the swapping, a bank usually does the facilitating for a commission fee of 1% of the deal. So let’s say a Canadian company called Lumber For All, Inc. has a $50 million loan with a U.S. bank at a floating interest rate of LIBOR plus 3%. They start to worry that U.S. interest rates might go up, leading to a stronger dollar against the Canadian dollar, resulting in a bigger challenge to repay the loan with more expensive interest rates and principal. So Lumber For All says to themselves, “Why don’t we swap our floating rate loan with a fixed rate loan in Australian dollars? Interest rates are low there, and the Australian dollar might depreciate against the Canadian dollar, eh?”

So a local branch of an international bank helps Lumber enter into a circus swap with another company that converts the U.S. floating rate loan into a fixed rate loan in Australian dollars. If Lumber is correct, they will save millions of dollars on the loan. ​It's a bit of a highwire act.