The volume of wealth that changes hands in the currency market dwarfs that of all other financial markets. Specialist brokers, banks, central banks, corporations, portfolio managers, hedge funds and retail investors trade staggering volumes of currencies throughout the world on a continuous basis. (Learn more about advanced education alternatives for forex traders in "Forex Careers: 5 Professional Designations.")

Participants are exposed to currency risk because of the sheer size of transactions in the currency market. This is the financial risk that arises from potential changes in the exchange rate of one currency in relation to another. Adverse currency movements can often crush positive portfolio returns or diminish the returns of an otherwise prosperous international business venture. The currency swap market is one way to hedge that risk.

Currency Swaps in Forex Markets

A currency swap is a financial instrument that helps parties swap notional principals in different currencies and thus pay interest on the received currency. The purpose of currency swaps is to hedge against risk exposure associated with exchange rate fluctuations, ensure receipt of foreign monies and to achieve better lending rates.

Currency swaps are comprised of two notional principals that are exchanged at the beginning and end of the agreement. Companies that have exposure to foreign markets can often hedge their risk with currency swap forward contracts.

In the following examples, transaction costs have been omitted to simplify explaining payment structure:

1. Party A pays a fixed rate on one currency, Party B pays a fixed rate on another currency.

Consider a U.S. company (Party A) is looking to open up a plant in Germany where its borrowing costs are higher in Europe than at home. Assuming a 0.6 euro/USD exchange rate, the U.S. company needs €3 million to complete an expansion project in Germany. The company can borrow €3 million at 8% in Europe, or $5 million at 7% in the U.S. The company borrows the $5 million at 7%, and then enters into a swap to convert the dollar loan into euros. The counterparty of the swap may likely be a German company that requires $5 million in U.S. funds. Likewise, the German company will be able to attain a cheaper borrowing rate domestically than abroad – let's say that the Germans can borrow at 6% within from banks within the country's borders.

Now, let's take a look at the physical payments made using this swap agreement. At the outset of the contract, the German company gives the U.S. company the 3 million euros needed to fund the project, and in exchange for the 3 million euros, the U.S. company provides the German counterparty with $5 million.

Subsequently, every six months for the next three years (the length of the contract), the two parties will swap payments. The German bank pays the U.S. company the product of $5 million (the notional amount paid by the U.S. company to the German bank at initiation), 7% (the agreed upon fixed rate), and .5 (180 days / 360 days). This payment would amount to $175,000 ($5 million x 7% x .5). The U.S. company pays the German bank the product of €3 million (the notional amount paid by the German bank to the U.S. company at initiation), 6% (the agreed upon fixed rate), and .5 (180 days / 360 days). This payment would amount to €90,000 (€3 million x 6% x .5).

The two parties would exchange these fixed two amounts every six months. Three years after initiation of the contract, the two parties would exchange the notional principals. Accordingly, the U.S. company would pay the German company €3 million and the German company would pay the U.S. company $5 million.

2. Party A pays a fixed rate on one currency, Party B pays a floating rate on another currency.

Using the example above, the U.S. company (Party A) would still make fixed payments at 6.0% while the German bank (Party B) would pay a floating rate (based on a predetermined benchmark rate, such as LIBOR).

These types of modifications to currency swap agreements are usually based on the demands of the individual parties in addition to the types of funding requirements and optimal loan possibilities available to the companies. Either party A or B can be the fixed rate pay while the counterparty pays the floating rate.

3. Part A pays a floating rate on one currency, Party B also pays a gloating rate based on another currency.

Both the U.S. company (Party A) and the German bank (Party B) make floating rate payments based on a benchmark rate. (Learn how these derivatives work in "An Introduction to Swaps.")

Hedging Currency Risk in Forex Markets

Currency translations are big risks for companies that conduct business across borders. A company is exposed to currency risk when income earned abroad is converted into the money of the domestic country, and when payables are converted from the domestic currency to the foreign currency.

Recall our plain vanilla currency swap example using the U.S. company and the German company. There are several advantages to the swap arrangement for the U.S. company. First, the U.S. company is able to achieve a better lending rate by borrowing at 7% domestically as opposed to 8% in Europe. The more competitive domestic interest rate on the loan, and consequently the lower interest expense, is most likely the result of the U.S. company being better known in the U.S. than in Europe. It is worthwhile to realize that this swap structure essentially looks like the German company purchasing a euro-denominated bond from the U.S. company in the amount of €3 million.

The advantages of this currency swap also include assured receipt of the €3 million needed to fund the company's investment project and other instruments, such are forward contracts, can be used simultaneously to hedge exchange rate risk.

Investors benefit from hedging foreign exchange rate risk as well. A portfolio manager who must purchase foreign securities with a heavy dividend component for an equity fund could hedge risk by entering into a currency swap. To hedge against exchange rate volatility, a portfolio manager could execute a currency swap in the same way as the company. There is the potential that favorable currency movements will not have a beneficial impact on the portfolio because hedging will remove the foreign exchange rate volatility. (For further reading on reducing volatility, see "Hedging With Puts and Calls.")

Reasons Currency Hedging is Important

This risk is also applicable to mutual funds and ETFs. If you own a portfolio of stocks based in the U.K., for instance, you’re exposed to currency risk. The value of your fund can decline due to changes in the exchange rate between the U.K. and the U.S., which is one of several reasons why currency hedging is important. Below, we've outlined some currency hedging factors for traders to keep in mind.

1. Eliminate Risk Over the Long Term. 

Suppose you own a U.K.-denominated fund. Your investment objective is to own companies based in that country that perform well. The exchange rate between the dollar and the pound will change over time, based on economic and political factors. For this reason, you need to hedge your currency risk to benefit from owning your fund over the long term.

2. Foreign Stocks Add Portfolio Diversity.

You want to own companies in the United States and in foreign countries to properly diversify your portfolio. For example, frontier and emerging markets are attractive to investors who want to take more risk and achieve higher returns. Since most investors use foreign-based investments, they can reduce their risk exposure using currency-hedged ETFs and mutual funds.

3. Forward Contracts.

Many funds and ETFs hedge currency risk using forward contracts, and these contracts can be purchased for every major currency. A forward contract, or currency forward, allows the purchaser to lock in the price they pay for a currency. In other words, the exchange rate is locked in place for a specific period of time. However, there is a cost to buy forward contracts. The contract protects the value of the portfolio if exchange rates make the currency less valuable. Using the U.K. example, a forward contract protects an investor when the value of the pound declines relative to the dollar.

On the other hand, if the pound becomes more valuable, the forward contract isn’t needed. Funds that use currency hedging believe that the cost of hedging will pay off over time. The fund's objective is to reduce currency risk and accept the additional cost of buying a forward contract.

4. Hedging Large Currency Declines.

A currency hedging strategy can protect the investor if the value of a currency falls sharply. Consider two mutual funds that are made up entirely of Brazilian-based companies. One fund does not hedge currency risk.

The other fund contains the exact same portfolio of stocks, but purchases forward contracts on the Brazilian currency, the real. If the value of the real stays the same or increases compared to the dollar, the portfolio that is not hedged will outperform, since that portfolio is not paying for the forward contracts.

However, when the Brazilian currency declines in value, the hedged portfolio performs better, since that fund has hedged against currency risk. Political and economic factors can cause large fluctuations in exchange rates. In some cases, currency rates can be very volatile. A hedged portfolio incurs more costs, but can protect your investment in the event of a sharp decline in a currency’s value.

The Bottom Line

Parties with significant forex exposure can improve their risk and return profile through currency swaps. Investors and companies can choose to forgo some return by hedging currency risk that has the potential to negatively impact an investment.

Volatile currency rates can make managing global business operations very difficult. A company that does business around the world can have its earnings deeply impacted by large swings in currency rates. Currency risk doesn't only affect companies and international investors, as changes in currency rates around the globe result in ripple effects that impact market participants throughout the world. Fortunately, hedging this currency risk is entirely possible using currency swaps.