What is a Currency Swap?

Overview

• A currency swap, also known as a cross-currency swap, involves the exchange of interest—and sometimes of principal—in one currency for the same in another currency. The interest payments are exchanged at fixed dates. Interest rates can be fixed or floating.
• The two parties agree in advance whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction. Some currency swaps are for notional principal amounts, and the principal amounts are not actually exchanged between the parties. If there is an exchange of principal at the start of the deal, the exchange will be reversed when the contract reaches maturity.
• It is common for the contract to specify that interest rate payments will be calculated quarterly and exchanged semi-annually.
• Interest payments are normally not netted since they are in different currencies.
• In the United States (and many other countries) the law does not require currency swaps to be shown on a company´s balance sheet.
• Even though a Currency Swap is considered a foreign exchange transaction, it is not the same thing as a Foreign Exchange Swap (also known as forex swap or FX swap).

Fixed to fixed, floating to floating, or fixed to floating

There are three variations on the exchange of interest rates:

• Fixed-rate to fixed rate
• Fixed-rate to floating rate
• Floating rate to floating rate (this type of swap is also known as a basis swap)

Examples

Company A is initially obligated to pay a fixed interest rate on a loan denominated in euros. By using a currency swap, Company A can swap that to a rate in United States dollars, and the exchange rate can be either fixed or floating.

Why?

Early on, currency swaps developed as a way of circumventing exchange controls imposed by governments. Today, they are utilized for other reasons and have become important financial instruments for banks, investors and multinational corporations.

A company can, for instance, use a currency swap to hedge a long-term investment and change their interest rate exposure. Another reason behind the existence of the currency swap is that a company which is based in one country and is doing business in another can use a currency swap to get more favourable interest rate terms and conditions for a loan denominated in the local currency than the rates offered by the local banks.

And even though they started out as a way to circumvent national law, governments today use currency swaps as well. One notable example is from October 2018, when the governments of India and Japan signed a bilateral currency swap agreement worth 75 billion USD to stabilise India's forex and capital markets.

Pricing

Traditionally, the pricing in currency swap contracts has been expressed as the London Interbank Offered Rate (LIBOR) plus or minus a certain number of points.

After a number of scandals, the validity of LIBOR as a benchmark has come into question, and the use of LIBOR in currency swaps is being phased out in favour of other benchmarks, especially the Secured Overnight Financing Rate (SOFR).

The US Federal Reserve and the UK financial authorities have announced that LIBOR will not be used in this context after June 30, 2023.

Implied exchange rate

The ratio between the two principal amounts creates an implied exchange rate.

Example: This swap involves 10 million euros and 11 million U.S. dollars. The implied EUR/USD exchange rate is, therefore, 1.10.

When the contract reaches its maturity, the two principal amounts will be exchanged. Because of this, there is an exchange rate risk involved in the currency swap, as the market exchange rate for EUR/USD might not be 1.10 on the maturity date.