Currency Swap

Posted on by user

Currency Swap: Definition, Uses, and Risks

A currency swap is a financial agreement in which two parties exchange cash flows in different currencies for a set period. These arrangements typically involve exchanging principal amounts (either actually or notionally) and swapping interest payments denominated in each currency. Currency swaps help organizations manage currency and interest-rate exposure and access foreign funding on more favorable terms.

How Currency Swaps Work (Overview)

  • Parties agree on the currencies, notional/principal amounts, exchange rate (implicit if principals are exchanged), interest rates, payment schedule, and maturity.
  • Optional initial principal exchange: principals may be physically exchanged at the start (creating an implicit exchange rate) or left notional and used only to calculate payments.
  • Periodic interest payments: each party pays interest in the currency it received (fixed, floating, or a mix).
  • Final exchange: at maturity the principal amounts are usually re-exchanged at the agreed rate if they were actually exchanged.
  • Netting and settlement: payments may be netted and converted into a single currency depending on the contract terms.

Note: In practice many currency swaps use notional principals (no physical principal exchange) and are used primarily to exchange interest obligations.

Fast technical point: strictly speaking, a “currency swap” often refers to fixed-for-fixed cash flows, while agreements involving one or more floating legs are called “cross-currency swaps.” In common usage the terms are used interchangeably.

Why Businesses Use Currency Swaps

  • Hedge currency risk: shield long-term obligations from exchange-rate volatility.
  • Access foreign capital: borrow effectively in another currency without entering that market directly.
  • Lower borrowing costs: exploit comparative advantages in different capital markets.
  • Manage assets and liabilities: match the currency denomination of assets and liabilities for banks and multinational firms.

Typical Execution Steps

  1. Agreement on terms: currencies, notionals, interest rates, schedule, and maturity.
  2. (Optional) Initial exchange of principals at the agreed rate.
  3. Periodic exchange of interest payments according to the schedule.
  4. Periodic principal exchanges if specified.
  5. Final re-exchange of principals at maturity (if principals were exchanged).
  6. Settlement and close-out, including any adjustments for early termination or restructuring.

Types of Interest Exchanges

  • Fixed-for-fixed
  • Floating-for-floating (often called a basis swap)
  • Fixed-for-floating

Interest payments are often calculated quarterly and exchanged semiannually, but contracts can be tailored as needed. Because payments are in different currencies, they’re generally not netted unless the contract specifies netting and conversion rules.

Risks to Manage

  • Counterparty risk: the other party may default. Mitigants include dealing with reputable institutions, collateral, and credit support annexes.
  • Exchange-rate risk: re-exchanging principals or netting in one currency exposes parties to currency movements.
  • Interest-rate risk: floating-rate legs or changing market rates can change the swap’s value.
  • Liquidity risk: exiting a long-term swap early can be difficult or costly if markets are illiquid.
  • Valuation risk: complex structures or thinly traded currencies make accurate valuation harder, complicating accounting and risk management.

How Currency Swaps Differ from Related Instruments

  • FX (foreign exchange) swaps: typically short-term (often under one year) and mainly for liquidity management; usually involve exchange of principal with reversal at maturity but no periodic interest exchanges.
  • Interest rate swaps: exchange interest payments in the same currency (no currency exchange); used to manage interest-rate exposure only.
  • Forwards and futures: lock in an exchange rate for a future single transaction; used for short- to medium-term hedging rather than a series of payments over time like swaps.

Example (Simplified)

  • U.S. firm: $10 million loan at 3% (USD).
  • Japanese firm: ¥1 billion loan at 1% (JPY). Assume 1 USD = 100 JPY, so notionals are equivalent.
  • Swap agreement: U.S. firm pays 1% on ¥1 billion; Japanese firm pays 3% on $10 million.
  • Annual payments: U.S. firm pays ¥10 million; Japanese firm pays $300,000. Payments can be converted and netted at the prevailing exchange rate if the contract allows.
  • Outcome: Each firm effectively matches loan obligations to its revenue currency and can benefit from each other’s borrowing rates.

Benchmark Rates: SOFR (Brief)

SOFR (Secured Overnight Financing Rate) is a widely used benchmark for U.S. dollar overnight funding, based on repo transactions backed by U.S. Treasuries. It serves as a robust alternative to LIBOR for determining floating-rate payments in many modern swap agreements.

Bottom Line

Currency swaps are flexible tools for managing cross-currency financing and interest-rate exposure. They allow firms to access foreign capital, hedge long-term currency risk, and tailor interest-rate profiles. However, they introduce counterparty, exchange-rate, liquidity, and valuation risks that require careful structuring and active risk management.