What Is a Currency Swap?

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of interest—and sometimes of principal—in one currency for the same in another currency. Interest payments are exchanged at fixed dates through the life of the contract. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet.

The Basics of Currency Swaps

Currency swaps were originally done to get around exchange controls, governmental limitations on the purchase and/or sale of currencies. Although nations with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated controls nowadays.

So swaps are now done most commonly to hedge long-term investments and to change the interest rate exposure of the two parties. Companies doing business abroad often use currency swaps to get more favorable loan rates in the local currency than they could if they borrowed money from a bank in that country.

How a Currency Swap Works

In a currency swap, the parties agree in advance whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction. The two principal amounts create an implied exchange rate. For example, if a swap involves exchanging €10 million versus $12.5 million, that creates an implied EUR/USD exchange rate of 1.25. At maturity, the same two principal amounts must be exchanged, which creates exchange rate risk as the market may have moved far from 1.25 in the intervening years.

Pricing is usually expressed as London Interbank Offered Rate (LIBOR), plus or minus a certain number of points, based on interest rate curves at inception and the credit risk of the two parties.

A currency swap can be done in several ways. Many swaps use simply notional principal amounts, which means that the principal amounts are used to calculate the interest due and payable each period but is not exchanged.

If there is a full exchange of principal when the deal is initiated, the exchange is reversed at the maturity date. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Interest rates can be fixed or floating.

Exchange of Interest Rates in Currency Swaps

There are three variations on the exchange of interest rates: fixed rate to fixed rate; floating rate to floating rate; or fixed rate to floating rate. This means that in a swap between euros and dollars, a party that has an initial obligation to pay a fixed interest rate on a euro loan can exchange that for a fixed interest rate in dollars or for a floating rate in dollars. Alternatively, a party whose euro loan is at a floating interest rate can exchange that for either a floating or a fixed rate in dollars. A swap of two floating rates is sometimes called a basis swap.