A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either act on their own or as an agent for a non-financial corporation. The purpose of a currency swap is to hedge exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.
A currency swap is similar to an interest rate swap, except that in a currency swap, there is often an exchange of principal, while in an interest rate swap, the principal does not change hands.
In currency swap, on the trade date, the counter parties exchange notional amounts in the two currencies. For example, one party receives $10 million British pounds (GBP), while the other receives $14 million U.S. dollars (USD). This implies a GBP/USD exchange rate of 1.4. At the end of the agreement, they will swap again using the same exchange rate, closing out the deal.
Since swaps can last for a long time, depending on the individual agreement, the exchange rate in the market place (not on the swap) can change dramatically over time. This is one of the reasons institutions use these currency swaps. They know exactly how much money they will receive and have to pay back in the future.
During the term of the agreement, each party pays interest periodically, in the same currency as the principal received, to the other party. There are number of ways interest can paid. It can 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.
On the maturity date, the parties exchange the initial principal amounts, reversing the initial exchange at the same exchange rate.
Examples of Currency Swaps
Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan. On trade date, Company A exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP (equivalent to 1.35 GBP/USD).
During the life of the transaction, Company A pays a fixed rate in GBP to Company B in return for USD six-month LIBOR.
The USD interest is calculated on $100 million USD, while the GBP interest payments are computed on the 74 million pound amount.
At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100 million USD and Company B receives 74 million pounds.
Company A and B might engage in such a deal for a number of reasons. One possible reason is the company with US cash needs British pounds to fund a new operation in Britain, and the British company needs funds for an operation in the US. The two firms seek each other and come to an agreement where they both get the cash they want without having to go to a bank to get loan, which would increase their debt load. As mentioned, currency swaps don't need to appear on a company's balance sheet, where as taking a loan would.
Having the exchange rate locked in lets both parties know what they will receive and what they will pay back at the end of the agreement. While both parties agree to this, one may end up better off. Assume in the scenario above that shortly after the agreement the the USD starts to fall to a rate of 0.65 USD/GBP. In this case, Company B be would have been able to receive $100 million USD for only $65 million GBP had they waited a bit longer on making an agreement, but instead they locked in at $74 million GBP.
While the notional amounts are locked in are and not subject to exchange rate risk, the parties are still subject to opportunity costs/gains in that ever changing exchange rates (or interest rates, in the case of a floating rate) could mean one party is paying or more less than they need to based on current market rates.