How Do Currency Swaps Work?

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 nonfinancial 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.

Key Takeaways

In a currency swap, 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 nonfinancial 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 counterparties 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 why 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 the coming years, then 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 a number of ways interest can be paid. Both parties can pay a fixed or floating rate, or one party may pay a floating rate while the other pays a fixed rate.

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 United States. 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.

Who uses currency swaps?

Currency swaps are used by various financial institutions and multinational corporations that have exposure to multiple currencies. Some examples include multinational corporations, banks, investment funds, governments and central banks, and international organizations like the International Monetary Fund (IMF).

Why use currency swaps?

Institutions use currency swaps for a number of reasons.

Currency swaps allow companies to hedge their foreign exchange exposures.
Currency swaps can help lower financing costs, as it may be cheaper to borrow in a foreign currency.
Another reason why currency swaps are used is to gain access to a foreign currency. Companies may find it difficult to attain the foreign currency through traditional means and may need that foreign currency to make payments.
Finally, currency swaps are used to take advantage of interest rate differentials between two countries.

Where are currency swaps held?

Currency swaps are over-the-counter (OTC) financial instruments. This means they are not traded on a centralized exchange. Rather, the currency swaps are negotiated between two parties. Currency swaps are typically held by the two parties to the contract, although in some cases, one or both parties may choose to sell or transfer their position to another party. These transfers are subject to the consent of the other party and may be subject to additional fees or restrictions.

What are the limitations of currency swaps?

Like any financial instrument, currency swaps possess several limitations and risks.

First, there is counterparty risk inherent in currency swaps. This means that there is a risk that one of the parties may default on their obligations.

Also, given the complexity of currency swaps, some financial institutions may find it difficult to use them effectively.

Another limitation of currency swaps is that there may be significant costs associated with entering and managing the swap agreement, depending on the structure. These costs may be attributed to swap fees and hedging costs.

Finally, currency swaps have limited liquidity, which makes it difficult to enter or exit a swap agreement at a favorable rate.

What are alternatives to currency swaps?

Other financial instruments can be used in lieu of currency swaps. These include forward contracts and call options. Also, instead of using currency swaps, companies can use natural hedges to manage currency risk. Finally, companies can choose to remain in their domestic market and avoid foreign currency transactions altogether, eliminating the need for currency swaps or other hedging strategies.

The Bottom Line

Currency swaps are financial contracts between two parties to exchange a specific amount of one currency for an equivalent amount of another currency. The purpose of currency swaps is to reduce currency risk, achieve lower financing costs, or gain access to a foreign currency.

In a currency swap, the two parties agree to exchange notional amounts of currencies at an agreed-upon exchange rate and then, at a specified future date, reverse the transaction at a prearranged rate. The swap rate is the difference between the two exchange rates, and it represents the cost of borrowing one currency compared to the other.

Currency swaps are widely used by multinational corporations and financial institutions to manage their foreign exchange exposure.