# Foreign Currency (FX) Swap: Definition, How It Works, and Types

![Foreign Currency Swap](https://www.investopedia.com/thmb/aY-uak2Et76NM-npYHGSP38iOhQ=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/foreign-currency-swaps.asp-final-02bae8a217974bafb0705ac48de59d8d.png)

*— Investopedia / Theresa Chiechi*

## What Is a Foreign Currency Swap?

A foreign [currency swap](https://www.investopedia.com/terms/c/currencyswap.asp) is an agreement between two foreign parties to swap interest payments on a loan made in one currency for interest payments on a loan made in another currency.

A foreign currency swap can involve exchanging principal, as well. This would be exchanged back when the agreement ends. Usually, though, a swap involves [notional principal](https://www.investopedia.com/terms/n/notionalprincipalamount.asp) that's just used to calculate interest and isn't actually exchanged.

### Key Takeaways

*   A foreign currency swap is an agreement between two parties to swap interest rate payments on their respective loans in their different currencies.
*   The agreement can also involve swapping principal amounts of loans.
*   The two main types of swaps are fixed-for-fixed rate swaps and fixed-for-floating rate swaps.
*   Foreign currency swaps can help companies borrow at a rate that's less expensive than that available from local financial institutions.
*   They can also be used to hedge (or protect) the value of an existing investment against the risk of exchange rate fluctuations.

## Understanding Foreign Currency Swaps

One purpose of engaging in a [currency swap](https://www.investopedia.com/ask/answers/042315/how-do-currency-swaps-work.asp) is to procure loans in foreign currency at more favorable interest rates than might be available when borrowing directly in a foreign market.

During the financial crisis in 2008, the [Federal Reserve](https://www.investopedia.com/terms/f/federalreservebank.asp) allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes.

In a transaction arranged by investment banking firm, Salomon Brothers, the World Bank entered into the very first currency swap in 1981 with IBM. IBM swapped German Deutsche marks and Swiss francs to the World Bank for U.S. dollars.

Foreign currency swaps can be arranged for loans with [maturities](https://www.investopedia.com/terms/m/maturity.asp) as long as 10 years. Currency swaps differ from [interest rate swaps](https://www.investopedia.com/terms/i/interestrateswap.asp) in that they can also involve principal exchanges.

### The Process of a Foreign Currency Swap

In a foreign currency swap, each party to the agreement pays interest on the the other's loan principal amounts throughout the length of the agreement. When the swap is over, if principal amounts were exchanged, they are exchanged once more at the agreed upon rate (which would avoid [transaction risk](https://www.investopedia.com/terms/t/transactionrisk.asp)) or the [spot rate](https://www.investopedia.com/terms/s/spot_rate.asp).

Currency swaps have been tied to the [London Interbank Offered Rate](https://www.investopedia.com/terms/l/libor.asp) (LIBOR). LIBOR is the average interest rate that international banks use when borrowing from one another. It has been used as a benchmark for other international borrowers.

However, in 2023, the Secured Overnight Financing Rate (SOFR) will officially replace LIBOR for benchmarking purposes. In fact, as of the end of 2021, no new transactions in U.S. dollars use LIBOR (although it will continue to quote rates for the benefit of already existing agreements).

## Types of Swaps

Here are the main types of foreign currency swaps:

*   **[Fixed-for-Fixed Currency Swap](https://www.investopedia.com/terms/f/fixed-fixedswap.asp):** In a fixed-for-fixed currency swap, both parties agree to exchange fixed interest rate payments in two different currencies. This type of swap is commonly used when both parties want predictability in their interest payments, allowing them to avoid fluctuations from floating rates. 
*   **[Fixed-for-Floating Currency Swap](https://www.investopedia.com/terms/f/fixed_floatswap.asp):** A fixed-for-floating currency swap involves one party making fixed interest rate payments while the other makes payments based on a floating rate (such as SOFR). This type of swap is often used when one party wants certainty in their payments while the other party prefers to benefit from potential changes in interest rates. 
*   **Floating-for-Floating Currency Swap:** In a floating-for-floating currency swap, both parties exchange interest payments based on floating rates in their respective currencies. This swap is also known as a "basis swap" and is used when both parties want to benefit from the potential movement of interest rates in different markets. For instance, a company might exchange floating U.S. dollar payments based on LIBOR for floating Japanese yen payments based on a Japanese benchmark rate, allowing both parties to manage their exposure to different interest rate environments.
*   **Amortizing Currency Swap:** An amortizing currency swap is structured so that the notional amount reduces over time, aligning with a schedule of principal repayments. This type of swap is typically used when there’s a need to align the swap with an amortizing loan, such as in project finance. In this structure, both parties exchange interest payments on decreasing principal amounts.
*   **Accreting Currency Swap:** In contrast to an amortizing swap, an accreting currency swap involves the notional principal increasing over time. 
*   **Zero-Coupon Currency Swap:** A zero-coupon currency swap involves one party making regular interest payments while the other party defers all interest payments until the maturity date, making a lump sum payment at the end of the swap’s term. 

> **Fast Fact**
>
> Foreign currency swaps are a way of getting capital where it needs to go so that economic activity can thrive. Theses swaps provide governments and businesses access to potentially lower cost borrowing. They also can help them protect their investments from the effects of exchange rate risk.

## Reasons for Using Currency Swaps

### Decreasing Borrowing Costs

A common reason to employ a currency swap is to secure cheaper debt. For example, say that European Company A borrows $120 million from U.S. Company B. Concurrently, U.S Company A borrows 100 million euros from European Company A.

The exchange between them is based on a $1.2 spot rate, indexed to LIBOR. The two companies make the deal because it allows them to borrow the respective currencies at a favorable rate.

If a currency swap deal involves the exchange of principal, that principal will be exchanged again at the maturity of the agreement.

### Reducing Exchange Rate Risks

In addition, some institutions use currency swaps to reduce exposure to anticipated fluctuations in exchange rates. For instance, companies are exposed to exchange rate risks when they conduct business internationally.

Therefore, it can behoove them to hedge those risks by essentially taking opposite and simultaneous positions in the currency. U.S. Company A and Swiss Company B can take a position in each other’s currencies (Swiss francs and USD, respectively) via a currency swap for hedging purposes.

Then, they can unfold the swap later when the hedge is no longer needed. If they suffered a loss due to fluctuating exchange rates affecting their business activity, the profit on the swap can offset that.

## Risks Associated With Foreign Currency Swaps

The top risk with foreign currency swaps is currency risk. [Currency risk](https://www.investopedia.com/terms/c/currencyrisk.asp) arises from fluctuations in exchange rates between two currencies involved in the swap. When companies or financial institutions enter into a swap, they agree to exchange cash flows in different currencies at future dates. If/when the exchange rate moves, one party may end up paying significantly more in its domestic currency than anticipated. For example, if a company swaps U.S. dollars for euros and the euro strengthens, the company will need to pay more in dollars to meet its euro obligations.

Another key risk is [interest rate risk](https://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp). Foreign currency swaps often involve exchanging fixed or floating interest payments on the notional amounts of the two currencies. If interest rates in one country rise unexpectedly, the party receiving fixed interest payments in that currency may miss out on higher interest income. If interest rates decline, the party paying floating rates could face higher-than-expected costs.

Counterparty risk is another risk. In any swap agreement, the parties involved rely on each other to fulfill their obligations. If one party defaults, the other party may face financial losses. To mitigate this risk, companies often perform thorough due diligence on their counterparties or utilize clearinghouses for swap agreements. As is the case with most financial instruments, this risk cannot be eliminated.

Last, the [liquidity risk](https://www.investopedia.com/articles/trading/11/understanding-liquidity-risk.asp) associated with foreign currency swaps is another factor to consider. These swaps typically have long maturities, and the liquidity of certain currencies can fluctuate over time. If market conditions change and a party wants to exit the swap early, they may find it difficult to find a willing counterparty, especially if they wish to trade or exchange out of their position.  

## Foreign Currency Swap vs. Foreign Exchange Trade

A currency swap and a [forex trade](https://www.investopedia.com/articles/forex/11/why-trade-forex.asp) are both financial instruments used to exchange currencies. A currency swap involves the exchange of principal amounts in different currencies, along with a series of interest payments over time. Meanwhile, a forex trade is a more straightforward and shorter-term transaction that involves the immediate exchange of one currency for another. 

Forex trades can either be spot transactions where the exchange happens on the spot at the current market rate or forward transactions where the currencies are exchanged at a specified future date but with the exchange rate agreed upon now. Forex trading is primarily used by investors and traders who aim to profit from short-term fluctuations in exchange rates, and it’s the backbone of the global forex market, which is the most liquid financial market in the world.

Another important difference lies in the purpose of each transaction. Currency swaps are generally used for hedging or long-term financial management. For example, a U.S. company with operations in Europe might use a currency swap to borrow euros at a lower interest rate than what’s available domestically while swapping back into U.S. dollars. Forex trades are more generally used by traders to [speculate](https://www.investopedia.com/terms/s/speculation.asp) on the movements of exchange rates, hoping to buy low and sell high (though it could also be used by corporations for short-term needs as well).  

## Why Do Companies Do Foreign Currency Swaps?

Foreign currency swaps serve two essential purposes. They offer a company access to a loan in a [foreign currency that can be less expensive](https://www.investopedia.com/terms/f/fcfd.asp) than when obtained through a local bank. They also provide a way for a company to hedge (or protect against) risks it may face due to fluctuations in foreign exchange.

## What Are the Different Types of Foreign Currency Swaps?

Foreign currency swaps can involve the exchange of fixed-rate interest payments on currencies. Or, one party to the agreement may exchange a fixed-rate interest payment for the floating-rate interest payment of the other party. A swap agreement may also involve the exchange of the floating rate interest payments of both parties.

## When Did the First Foreign Currency Swap Occur?

The first foreign currency swap is purported to have taken place in 1981 between the World Bank and IBM Corporation.

## The Bottom Line

Foreign currency swaps are financial agreements where two parties exchange principal and interest payments in different currencies, allowing them to manage currency and interest rate risk. These swaps are commonly used by companies and governments to secure better financing terms or hedge against long-term currency fluctuations. 

> **Article Sources**
>
> 1.  Federal Reserve System. "[Credit and Liquidity Programs and the Balance Sheet](https://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm)."
>     
> 2.  The World Bank. "[70 Years Connecting Capital Markets to Development](https://thedocs.worldbank.org/en/doc/981111541019927135-0340022018/original/70yearschapterfour.pdf)," Chapter 4.
>     
> 3.  The Federal Reserve System. "[Goodbye to All That: The End of LIBOR](https://www.federalreserve.gov/newsevents/speech/quarles20211005a.htm)."