What Is a Currency Swap?
A currency swap refers to a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and then repay over time according to an agreed-upon contract that reflects interest payments and possibly amortization of principal. In a currency swap, the cash flows are similar to those in a spot and forward foreign exchange transaction.
Definition 2
A currency swap is a contract in which two parties agree to exchange principal and interest payments in different currencies.
More Thorough Understanding of the Term
A currency swap is a popular type of swap that is used in case of an exchange of cash flows between to currencies to hedge risk. In its simplest form, this involves exchanging principal and interest payments in one currency for principal and interest payments in another currency.
A currency swap agreement requires the principal to be specified in each of the two currencies. The principal amounts are usually exchanged at the beginning, and at the end of the life of the swap usually the principal amount are chosen to be approximately equivalent using the exchange rate at the swap’s initiation.
The parties agree to exchange an identical amount of principal in various currencies at the start of the swap, followed by interest payments in those currencies over a predetermined time period. The parties exchange the principal amounts at the original exchange rate at the end of the swap.
The conversion of principal and interest payments in different currencies enables each party to manage their currency exposure and limit the risks associated with fluctuations in foreign exchange rates. To mitigate currency risk, a US corporation that has borrowed funds in euros can employ a currency exchange to convert the euros into dollars.
Benefits of Currency Swap
Currency swaps provide numerous advantages to businesses and investors. Among the advantages are:
- Currency swaps enable businesses and investors to manage their currency exposure and reduce the risks associated with currency swings.
- Currency swaps can reduce borrowing costs by gaining access to cheaper foreign currency finance.
- Currency swaps allow businesses and investors to borrow funds in foreign currencies, giving them access to overseas markets.
- Currency swaps can be used to mitigate the risks associated with international investments as part of a hedging strategy.
Example
Suppose a US company needs to borrow €10 million to finance a new project in Europe. The US company fears that the euro may decline against the US dollar by the time it needs to repay the loan. So the US company enters into currency swap agreements with the European bank. In the agreement, the parties agree on the exchange rate at the beginning of the swap, say €1 = $1.20. At the end of the swap, the US company pays the European bank the €10 million principal, while the European bank pays the US company the same amount in US dollars at the agreed exchange rate.
In Sentences
- Currency swaps are an important financial tool for firms and investors to use to control their currency risk.
- It is a two-party agreement to swap principal and interest payments in various currencies at a predetermined exchange rate.