Currency Swaps: Definition, How and Why They’re Done

What Is a Currency Swap?

Currency swaps are agreements between two parties to trade one currency for another at a preset rate over a given period.

These exchanges are more complex than simply changing denominations for accounting purposes. Instead, they set the stage for a large portion of global economic activity, allowing businesses to operate smoothly across borders and giving central banks powerful tools to manage monetary policy. According to the latest reliable data, global daily currency swaps were worth about $400 billion, or around 5% of the $8.1 trillion forex market.

Though currency swaps can be intricate, the basics will be familiar to anyone who has arrived at a foreign airport and stopped by an exchange booth to trade their money for the local currency.

Understanding Currency Swaps

Currencies were initially swapped to get around exchange controls, or legal limits on buying or selling currencies. However, although nations with weak or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated them.

As such, swaps are now most commonly done to hedge long-term investments and change the interest rate exposure of the two parties participating in the swap. Companies doing business abroad often use currency swaps to get more favorable loan rates in the local currency than they could if they borrowed money from a bank in that country.

In a currency swap, the parties decide upfront whether to exchange the principal amounts of the two currencies at the beginning of the transaction. These principal amounts establish an implicit exchange rate. For instance, swapping €10 million for $12.5 million implies a EUR/USD exchange rate of 1.25.

At the swap’s maturity, the same principal amounts are typically reexchanged. This creates exchange rate risk, as the market rate may have significantly diverged from the initial 1.25 over the swap’s duration.

Currency swap pricing is like negotiating the price of a new car. You begin with the base model price, then add or subtract costs based on your desired features and credit score. The interest rate for a currency swap is customized based on market conditions and the financial standing of the parties involved.

1. Starting point: The starting price for a swap is usually based on a benchmark interest rate that’s widely used in finance, such as the U.S. Federal Reserve’s overnight rate or SOFR.
2. Adjustments: This rate is adjusted up or down with small adaptations called “basis points”; these depend on the general pattern of interest rates at the time of the deal, as well as the credit risk of each party involved.
3. Final price: The result is the actual interest rate each party will pay in the currency swap.

Why Firms Use Currency Swaps

Currency swaps are flexible financial tools that are commonly used for the following purposes:

• Hedge currency risk: Multinational corporations use swaps to manage exposure to exchange rate fluctuations.
• Access foreign markets: Companies can effectively borrow in foreign currencies without entering those foreign credit markets.
• Costs: By tapping into markets with a comparative advantage, companies can lower their overall borrowing costs.
• Managing asset liability: Financial institutions use swaps to match the currency denomination of their assets and liabilities.

Steps of a Typical Currency Swap

Though currency swaps can vary depending on the parties involved, there are common steps that a typical currency swap follows.

1. Agreement: Two parties agree to exchange a specific amount of two different currencies. They set the terms, including the exchange rate, duration, and payment schedule.
2. Initial exchange: At the start of the swap, the principal amounts are exchanged at the agreed-upon rate. Each party receives the equivalent value in the other currency.
3. Interest payments: Throughout the swap’s duration, the parties exchange interest payments. These are generally done at predetermined intervals (e.g., quarterly, semiannually). Each party pays interest based on the interest rate of the currency they initially received.
4. Ongoing swaps: Depending on the swap structure, there may be periodic exchanges of principal. This helps manage exchange rate fluctuations over time.
5. Final exchange: At the swap’s maturity, the parties reexchange the principal amounts. This is usually done at the same exchange rate as the initial exchange.
6. Settlement and termination: Any remaining obligations are settled. This may include final interest payments or adjustments for market changes. The swap contract ends.

It’s worth noting that variations exist depending on the specific needs of the parties involved and market conditions. Some swaps may also include options for early termination or restructuring.

Currency Swap Risks

Like any speculative financial transaction, currency swaps come with several risks. These risks can be mitigated but not completely eliminated by the participants.

Counterparty Risk

This is the risk that one of the parties involved in the swap may default on their obligations, leaving the other party exposed to potential financial loss. Counterparty risk is mitigated by dealing with reputable financial institutions and using collateral or credit support annexes.

Exchange Rate Risk

If the swap involves netting payments in a single currency, changes in the exchange rate can affect the net amount payable. If not properly managed, this could lead to unexpected costs.

Interest Rate Risk

Fluctuations in interest rates can affect the value of the swap, especially if one leg of the swap has a floating interest rate. Companies should carefully manage interest rate risk to avoid adverse affecs on their financial positions.

Liquidity Risk

If one party needs to exit the swap before its maturity, there may be a lack of liquidity, making it difficult or expensive to unwind the position.

Valuation

The complexity of currency swaps can make them difficult to value, particularly if they involve less active currencies or complex structures. This can lead to inaccuracies in financial reporting or challenges in managing the swap’s performance over time.

Currency Swaps vs. Forex and Interest Rate Swaps

Currency swaps are sometimes confused with foreign exchange (forex or FX) swaps or interest rate swaps. While currency swaps share elements with those trades, there are fundamental differences between them.

Duration

Forex swaps are primarily used for short-term liquidity management; they typically last less than a year. Currency swaps are medium-to-long-term and can span several years. This longer duration allows them to serve broader strategic purposes, such as hedging against more enduring exchange rate fluctuations or gaining access to foreign capital markets.

Stages

FX swaps involve a simple exchange of principal amounts at the beginning and end of the contract. Currency swaps often include periodic exchanges of interest payments in different currencies during the life of the agreement.

Number of Currencies

Interest rate swaps are done with a single currency and focus on managing interest rate risk. Currency swaps introduce a bit more complexity by involving two currencies. This means that currency swaps must account for interest rate differentials and exchange rate changes.

Principal and Interest Payments

Currency swaps differ from FX swaps and interest rate swaps since they involve the exchange of both principal and interest payments in different currencies over a longer term. Forex swaps are short-term currency exchanges without interest payments, while interest rate swaps involve exchanging interest payments in the same currency without principal exchange.

While interest rate swaps typically use a notional principal amount only for calculating interest payments, currency swaps often involve actual exchanges of principal amounts. This makes currency swaps a more comprehensive tool for managing currency and interest rate exposures simultaneously.

Currency Swap Example

Suppose that a U.S. company has taken out a 5-year, $10 million loan at a fixed interest rate of 3% in USD (U.S. dollars). Meanwhile, a Japanese company has a 5-year, ¥1 billion loan at a fixed interest rate of 1% in JPY (Japanese yen). The exchange rate between the two currencies is 1 USD = 100 JPY.

Both companies want to manage their currency risk and benefit from each other’s loan terms. Unlike foreign exchange transactions, currency swaps don’t have to involve the actual exchange of principal amounts. Instead, the principal amounts can be notional and serve as the basis for calculating the interest payments.

Here’s what’s agreed:

1. The U.S. company’s notional amount is $10 million.
2. The Japanese company’s notional amount is ¥1 billion (equivalent to $10 million at the hypothetical exchange rate)
3. The U.S. company agrees to pay 1% interest on ¥1 billion to the Japanese company.
4. The Japanese company agrees to pay 3% interest on $10 million to the U.S. company.

For each of the five years of the swap, the U.S. company pays 1% × ¥1 billion = ¥10 million. In return, the Japanese company pays 3% × $10 million = $300,000 each year.

These payments can be made directly in the respective currencies or netted and converted to a single currency using the prevailing exchange rate at the time of payment. For example, if the exchange rate when an interest payment is made is 1 USD = 100 JPY (using a round figure to make the calculations below easy to follow), then:

• ¥10 million would be equivalent to approximately $100,000.
• The net payment would then be $300,000 – $100,000 = $200,000, which the Japanese company would pay to the U.S. company.
• This process repeats each year for the duration of the swap.

When the swap period ends after five years, the contract terminates, and there is no exchange of the principal amounts since they were only notional and used for calculating the interest payments. Each company remains responsible for its original loan in its respective currency.

The swap allows each company to match its loan obligations to its income currency. The U.S. firm effectively turns its dollar-denominated loan into a yen-denominated one, which could be beneficial if it has yen income from Japanese operations. The Japanese company does the opposite. If the U.S. company can’t access the Japanese credit market directly (or vice versa), this swap allows it to benefit indirectly from the lower Japanese interest rates.

Exchange of Interest Rates in Currency Swaps

There are three variations on the exchange of interest rates:

• fixed rate to fixed rate
• floating rate to floating rate
• fixed rate to floating rate

In a swap between euros and dollars, a party with an initial obligation to pay a fixed interest rate on a loan in euros can exchange that for a fixed interest rate in dollars or a floating rate in dollars. Alternatively, a party whose euro loan is at a floating interest rate can exchange that for either a floating or a fixed rate in dollars. A swap of two floating rates is sometimes called a basis swap.

Interest rate payments are usually calculated quarterly and exchanged semiannually, although swaps can be structured as needed. Interest payments are generally not netted because they are in different currencies. If the interest payments were netted, it would mean that instead of each party making separate interest payments to the other, they would calculate the difference between what they owe each other. Only the party owing more would make a payment to make up the difference.

The Bottom Line

A currency swap is a financial agreement between two parties to exchange principal amounts and interest payments in different currencies over a specific period. Companies or financial institutions typically use this to manage or hedge their exposure to fluctuations in exchange rates.

In a currency swap, each party agrees to make interest payments to the other in the currency they are receiving based on a specific interest rate (which can be fixed or floating). At the end of the swap period, the parties either exchange or net out the principal amounts at an agreed-upon exchange rate.