What is a Currency Swap?
A currency swap is a transaction in which two parties exchange an equivalent amount of money with each other but in different currencies. The parties are essentially loaning each other money and will repay the amounts at a specified date and exchange rate. The purpose could be to hedge exposure to exchange-rate risk, to speculate on the direction of a currency, or to reduce the cost of borrowing in a foreign currency.
The parties involved in currency swaps are usually financial institutions, trading on their own or on behalf of a non-financial corporation. Currency swaps and FX forwards now account for a majority of the daily transactions in global currency markets, according to the Bank for International Settlements.
- Two parties exchange equivalent amounts of two different currencies, and trade back at a later specified date.
- Currency swaps are often offsetting loans, and the two sides often pay each other interest on amounts exchanged.
- Financial institutions conduct most of the FX swaps, often on behalf of a non-financial corporation.
- Swaps can be used to hedge against exchange-rate risk, speculate on currency moves, and borrow foreign exchange at lower interest rates.
How a Currency Swap Works
In a currency swap, or FX swap, the counter-parties exchange given amounts in the two currencies. For example, one party might receive 100 million British pounds (GBP), while the other receives $125 million. This implies a GBP/USD exchange rate of 1.25. At the end of the agreement, they will swap again at either the original exchange rate or another pre-agreed rate, closing out the deal.
FX Swaps and Exchange Rates
Swaps can last for years, depending on the individual agreement, so the spot market's exchange rate between the two currencies in question can change dramatically during the life of the trade. This is one of the reasons institutions use currency swaps. They know exactly how much money they will receive and have to pay back in the future. If they need to borrow money in a particular currency, and they expect that currency to strengthen significantly in coming years, a swap will help limit their cost in repaying that borrowed currency.
FX Swaps and Cross Currency Swaps
A currency swap is often referred to as a cross currency swap, and for all practical purposes the two are basically the same. But there can be slight differences. Technically, a cross currency swap is the same as an FX swap, except the two parties also exchange interest payments on the loans during the life of the swap, as well as the principal amounts at the beginning and end. FX swaps can also involve interest payments, but not all do.
There are number of ways interest can be paid. It can be paid at a fixed rate, floating rate, or one party may pay a floating while the other pays a fixed, or they could both pay floating or fixed rates.
In addition to hedging exchange-rate risk, this type of swap often helps borrowers obtain lower interest rates than they could get if they needed to borrow directly in a foreign market.
Real World Example
Consider a company that is holding U.S. dollars and needs British pounds to fund a new operation in Britain. Meanwhile, a British company needs U.S. dollars for an investment in the U.S. The two seek each other out through their banks and come to an agreement where they both get the cash they want without having to go to a foreign bank to get a loan, which would likely involve higher interest rates and increase their debt loads. Currency swaps don't need to appear on a company's balance sheet, while a loan would.