Foreign Currency Swap

A foreign currency swap is a bilateral agreement to exchange interest payments — and sometimes principal — denominated in two different currencies. It lets parties obtain financing in another currency or hedge exposure to exchange-rate and interest-rate movements over a multi-year horizon.

How it works

• Parties agree on two notional principal amounts, one in each currency, and the schedule of exchanges.
• Throughout the life of the swap they exchange interest payments calculated on the respective notional amounts. Payments can be fixed or floating rates.
• If principal is exchanged at inception, it is typically re‑exchanged at maturity at a pre‑agreed rate (to avoid transaction risk) or at the prevailing spot rate.
• Benchmarks for floating rates have shifted away from LIBOR; in many markets alternative reference rates such as SOFR are now used.

Main types

• Fixed-for-fixed: Both sides pay fixed interest rates in their currencies.
• Fixed-for-floating: One side pays a fixed rate; the other pays a floating rate (e.g., linked to SOFR).
• Floating-for-floating (basis swap): Both sides pay floating rates tied to different benchmarks.
• Amortizing swap: Notional principal declines over time to match loan amortization.
• Accreting swap: Notional principal increases over time.
• Zero-coupon swap: One party defers interest payments until maturity, making a lump-sum payment then.

Why companies use currency swaps

• Reduce borrowing costs: A firm can access a foreign currency at a cheaper rate than local markets by swapping obligations with a counterparty that has better access to the other currency.
• Hedge currency risk: Swaps can offset future currency exposure from foreign operations, investments, or liabilities.
• Manage interest-rate exposure: By choosing fixed or floating legs, parties can align cash flows with their risk preferences.

Example: A European company needing dollars and a U.S. firm needing euros can borrow in their domestic markets and swap payments, each effectively obtaining the foreign currency at potentially better terms than direct borrowing abroad.

Key risks

• Currency risk: Exchange-rate movements can increase the domestic-currency cost of foreign-currency obligations.
• Interest-rate risk: Changes in interest rates affect the relative value of fixed and floating payment streams.
• Counterparty risk: One party may default on its obligations; clearinghouses or collateral can mitigate but not eliminate this risk.
• Liquidity risk: Long-dated swaps and less-liquid currencies may be difficult to unwind before maturity.

Currency swap vs. spot/forward FX trade

• Currency swap: A long-term arrangement exchanging interest (and sometimes principal) over time; primarily used for financing or hedging.
• FX trade (spot/forward): A short-term or single exchange of currencies at the prevailing or pre-agreed rate; commonly used for immediate needs or speculation.

Brief history

The first widely cited currency swap occurred in 1981 between two major institutions. Since then, swaps have become a standard tool for corporations, financial institutions, and governments managing cross‑currency financing and risk.

Conclusion

Foreign currency swaps are versatile instruments for accessing cheaper foreign financing and managing currency and interest-rate exposures. They offer tailored, long-term solutions but carry currency, interest-rate, counterparty, and liquidity risks that participants must assess and manage.