A currency swap is the exchange of currencies between two parties. A currency swap agreement is crafted between participants, and it outlines the governing tenants of the exchange. Swap agreements are made for an array of reasons, including risk management, securing financing and generating future cash flows.
While the idea of a swap by definition normally refers to a simple exchange of property or assets between parties, a currency swap also involves the conditions determining the relative value of the assets involved. That includes the exchange rate value of each currency and the interest rate environment of the countries that have issued them.
How Does A Currency Swap Work?
In a currency swap operation, also known as a cross currency swap, the parties involved agree under contract to exchange the following: the principal amount of a loan in one currency and the interest applicable on it during a specified period of time for a corresponding amount and applicable interest in a second currency. Although such contracts can be extremely complex, they are often favoured by institutional hedgers and speculators.
What Is The Goal Of A Currency Swap?
Currency swaps are often used to exchange fixed-interest rate payments on debt for floating-rate payments; that is, debt in which payments can vary with the upward or downward movement of interest rates. However, participants can also use them for fixed rate-for-fixed rate and floating rate-for-floating rate transactions.
Each side in the exchange is known as a counterparty. Accordingly, a degree of counterparty risk exists in any swap contract. In the event that a participating corporation, bank or investor becomes insolvent, default on the currency swap agreement is possible. As a result, the solvent party may lose some or all allocated capital.
Typical Currency Swap
In a typical currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange spot rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received. Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another.
Currency Swap Example Using EUR/USD
To illustrate the functionality of a foreign exchange swap, assume that a European and American company arrange to swap U.S. dollars for euros. To do so, the currency swap for a EUR/USD transaction is carried out as follows.
Cross Currency Swap Agreement
In a cross currency basis swap, the European company would borrow US$1 billion and lend €500 million to the American company assuming a spot exchange rate of US$2 per EUR for an operation indexed to the London Interbank Rate (Libor), when the contract is initiated.
Throughout the length of the contract, the European company would periodically receive an interest payment in euros from its counterparty at Libor plus a basis swap price, and it would pay the American company in dollars at the Libor rate. When the contract comes to maturity, the European company would pay US$1 billion in principal back to the American company and would receive its initial €500 million in exchange.
The benefits for a participant in such an operation may include obtaining financing at a lower interest rate than available in the local market, and locking in a predetermined exchange rate for servicing a debt obligation in a foreign currency. In this way, the risk of a negative impact through adverse interest rate fluctuations is mitigated.
When Did Currency Swaps Start?
Currency swaps were first developed by financial institutions in the UK in the 1970s as a manner to circumvent currency controls imposed at that time by the government. The swap market was launched on a more formal basis in 1981, in a transaction in which the World Bank sought to reduce its interest rate exposure by borrowing dollars in the US market and exchanging them for Swiss franc and Deutsche mark debt obligations held by IBM.
U.S. Fed Expands Currency Swap Program Amid 2008 Financial Crisis
Amid the economic crisis of 2008, currency swaps were one tool central banks used to restore liquidity to the global credit markets. On 16 September 2008, the U.S. Federal Open Market Committee (FOMC) gave its foreign currency subcommittee the power to "enter into swap agreements with foriegn central banks as needed." Subsequently, the U.S. Federal Reserve (Fed) expanded its foriegn exchange swap program, trading U.S. dollars for an array of different currencies.
Differences Between Currency Swaps And FX Swaps
Among types of swaps, the Bank for International Settlements (or BIS) distinguishes "cross currency swaps" from "FX swaps."
Unlike in a cross currency swap, in an FX swap there are no exchanges of interest during the contract term and a differing amount of funds is exchanged at the end of the contract. Given the nature of each, FX swaps are commonly used to offset exchange rate risk, while cross currency swaps can be used to offset both exchange rate and interest rate risk.
Cross currency swaps are frequently used by financial institutions and multinational corporations for funding foreign currency investments, and can range in duration. Typically, a short term contract is one year in length, while long term contracts can extend for up to 30 years. FX swaps are commonly used by exporters and importers, and institutional investors that seek to hedge their positions. This currency exchange can range from one day to one year or longer in duration.
According to the 2013 Triennial Central Bank survey from BIS, FX swaps were the most actively traded foreign exchange instruments, at upwards of US$2.2 trillion daily, or about 42% of forex-related transactions. Trading of cross currency basis swaps, by contrast, totalled an average of US$54 billion daily.. By any measure, these values are enormous and speak to the size and liquidity of the global foreign exchange market.
A currency swap is the exchange of interest, principle, or both of different currencies. Also known as cross-currency swaps, these agreements are financial derivatives that offer a multitude of advantages to participants. Key upsides are the ability to hedge interest rate risk, secure financing and generate future cash flows. Currency swaps differ from FX swaps, which only outline the terms of a currency exchange, not interest rates.
Currency swaps are considered over-the-counter (OTC) derivatives. Subsequently, a degree of counterparty risk does exist in each transaction. And, unlike the liquidity of forex trading, holders of a currency swap agreement may lose some or all allocated capital in the event of counterparty default.
This article was last updated on 9th November 2021.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
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