What Is a Currency Swap?

A currency swap, also known as a cross-currency swap, is a financial arrangement where parties exchange interest and sometimes principal amounts in different currencies. This transaction involves recurring interest payments on fixed dates throughout the contract’s duration. Although it falls under foreign exchange transactions, it is not mandatory for companies to disclose currency swaps on their balance sheets.

Key Takeaways

• Currency swaps entail exchanging interest and sometimes principal amounts in different currencies.
• Companies operating internationally leverage currency swaps to access more favorable loan rates in local currencies compared to borrowing from local banks.
• Currency swaps are under foreign exchange transactions and do not require mandatory disclosure on a company’s balance sheet.
• Interest rate options in currency swaps include fixed to fixed, floating to floating, or fixed to floating rates.

The Basics of Currency Swaps

Initially created to circumvent exchange controls, which were restrictions on currency trading imposed by governments, currency swaps are now predominantly used to hedge long-term investments and manage interest rate risks. In the current landscape, most developed economies have abolished exchange controls. Companies engaging in global transactions opt for currency swaps to secure preferable loan rates in foreign currencies than what local banks offer.

Currency swaps serve as essential financial tools utilized by banks, investors, and multinational corporations.

How a Currency Swap Works

In a currency swap, the participating parties pre-determine whether they will exchange the principal amounts of the two currencies at the transaction’s onset. The principal amounts establish an implied exchange rate. For instance, a swap involving exchanging €10 million for $12.5 million reflects an implied EUR/USD exchange rate of 1.25. Upon maturity, the same principal amounts must be exchanged, introducing exchange rate risks due to potential market fluctuations.

Typically, pricing is based on the London Interbank Offered Rate (LIBOR) plus or minus a margin, accounting for interest rate curves and the parties’ credit risk. However, the impending phasing out of LIBOR has prompted the transition to the Secured Overnight Financing Rate (SOFR) by June 30, 2023, as per the Federal Reserve and UK regulators.

Currency swaps can be structured in various ways, with some using notional principal amounts for interest calculation without actual exchange. Moreover, full principal exchanges at the deal’s initiation are reversed at maturity. Maturity timelines for currency swaps are negotiable, often extending up to 10 years, offering flexibility in managing foreign exchange. Interest rates can be either fixed or floating.

Notably, India and Japan entered a $75 billion bilateral currency swap agreement in October 2018 to stabilize forex and capital markets in India.

Exchange of Interest Rates in Currency Swaps

Interest rate exchanges in currency swaps come in three variations: fixed rate to fixed rate, floating rate to floating rate, or fixed rate to floating rate. This means that in a swap involving euros and dollars, a party initially obliged to a fixed euro loan rate can switch to a fixed or floating dollar rate. Similarly, a party with a floating rate euro loan can opt for a floating or fixed dollar rate. A swap between two floating rates is known as a basis swap.

Interest payments are typically computed quarterly and exchanged semi-annually with the flexibility to structure swaps as needed. These interest payments, denominated in different currencies, are usually not offset.