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A currency swap involves two parties exchanging a notional principal and interest to gain exposure to a desired currency. Banks, multinational corporations and institutional investors use these essential instruments to lower borrowing costs. Basically, they work like this:

An American firm called ABC Company wants to expand into Brazil and a Brazilian firm called XYZ Companhia wants to expand into the U.S. Both companies would be subject to very high interest rates if they tried to take out a bank loan in the other market’s currency, but ABC can get a loan from an American bank at 4%, and XYZ can get a loan from a Brazilian bank at 5%.

ABC borrows the money that XYZ needs through an American bank, and XYZ borrows the funds ABC needs from a Brazilian bank. Assuming the exchange rate is 1.60 Brazilian real-to-1 U.S. dollar, and both companies need to borrow the same amount, XYZ receives $100 million from ABC, and ABC gets 160 million real from XYZ.

The firms agree to swap the notional values of the loans and to repay them in each loan’s currency. Both have reduced their debt by borrowing domestically and exchanging the loans.

However, the currency swap also means that both companies assume foreign exchange risk, which is the chance one currency will diminish in value relative to the other.

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