# Understanding Currency Swaps: Definition, Benefits, and Risks

![Currency Swap: A derivative contract that involves trading interest paymentsâand sometimes principalâin different currencies.](https://www.investopedia.com/thmb/oVOoru-90dO_oJjziUtUEo5kiDM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/currencyswap.asp-final-40e8b290579545099d1b7fd2f1369269.png)

*— Investopedia / Julie Bang*

> **Definition**
>
> Currency swaps are agreements between two parties to exchange one currency for another at a preset rate over a given period. 

## What Is a Currency Swap?

Currency swaps are agreements between two parties to trade one currency for another at a preset rate over a given period. These exchanges set the stage for a large portion of global economic activity, allowing businesses to operate smoothly across borders and giving central banks powerful tools to manage monetary policy. According to the latest reliable data, global daily currency swaps were worth about $400 billion, or around 5% of the $8.1 trillion forex market.

Though currency swaps can be intricate, the basics will be familiar to anyone who has arrived at a foreign airport and stopped by an exchange booth to trade their money for the local currency. Currency swaps are important in aiding international business operations and central banks. They play an integral role in currency risk management and loan rate advantages for global companies.

### Key Takeaways

*   Currency swaps play a crucial role in the global economy, facilitating cross-border business operations and providing central banks with tools to manage monetary policy efficiently.
*   They allow companies to secure more favorable loan rates in foreign currencies, often needed to effectively manage long-term investments and interest rate exposure.
*   Although primarily designed to mitigate risks like exchange rate fluctuations, currency swaps also come with potential risks, such as counterparty and interest rate risks, which must be carefully managed.
*   The distinction between currency swaps, forex swaps, and interest rate swaps lies chiefly in their duration and complexity, with currency swaps involving both interest and principal exchanges over an extended period.
*   A currency swap example demonstrates how companies in different countries can hedge against currency risk by exchanging interest payments based on notional principal amounts, effectively targeting favorable loan terms in foreign markets.

## How Currency Swaps Work

Currencies were initially swapped to get around [exchange controls](https://www.investopedia.com/terms/e/exchangecontrol.asp), or legal limits on buying or selling currencies. However, although nations with weak or developing economies generally use foreign exchange controls to limit speculation against their currencies, most developed economies have eliminated them.  

As such, swaps are now most commonly done to hedge long-term investments and change the interest rate exposure of the two parties participating in the swap. 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.

In a currency swap, the parties decide upfront whether to exchange the principal amounts of the two currencies at the beginning of the transaction. These principal amounts establish an implicit exchange rate. For instance, swapping €10 million for $12.5 million implies a EUR/USD exchange rate of 1.25.

At the swap's maturity, the same principal amounts are typically reexchanged. This creates exchange rate risk, as the market rate may have significantly diverged from the initial 1.25 over the swap's duration.

Currency swap pricing is like negotiating the price of a new car. You begin with the base model price, then add or subtract costs based on your desired features and credit score. The interest rate for a currency swap is customized based on market conditions and the financial standing of the parties involved.  

1.  **Starting point**: The starting price for a swap is usually based on a [benchmark](https://www.investopedia.com/terms/b/benchmark.asp) interest rate that's widely used in finance, such as the U.S. Federal Reserve's overnight rate or SOFR.
2.  **Adjustments**: This rate is adjusted up or down with small adaptations called "basis points"; these depend on the general pattern of interest rates at the time of the deal, as well as the [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp) of each party involved.
3.  **Final price**: The result is the actual interest rate each party will pay in the currency swap.  
    

> **Fast Fact**
>
> Technically, the phrase "currency swap" refers only to transactions involving the exchange of cash flows calculated on a fixed-rate–fixed-rate basis. Currency swaps where one or both payments are based on a floating rate of interest are, strictly speaking, "cross-currency swaps." However, in everyday financial discussions, these phrases are used loosely, with "currency swap" serving as the catch-all term.

## Benefits and Uses of Currency Swaps for Businesses

Currency swaps are flexible financial tools that are commonly used for the following purposes:

*   **Hedge currency risk**: Multinational corporations use swaps to manage exposure to exchange rate fluctuations.
*   **Access foreign markets**: Companies can effectively borrow in foreign currencies without entering those foreign credit markets.
*   **Costs**: By tapping into markets with a comparative advantage, companies can lower their overall borrowing costs.
*   **Managing asset liability**: Financial institutions use swaps to match the currency denomination of their assets and liabilities.

## Process of Executing a Currency Swap

While currency swaps can vary, they usually follow common steps.  

1.  **Agreement**: Two parties agree to exchange specific amounts of different currencies, setting terms like exchange rate, duration, and payment schedule.
2.  **Initial Principal Exchange**: At the start, principal amounts are exchanged at the agreed rate, with each party receiving equivalent value in the other currency.
3.  **Interest Payments**: Throughout the swap, interest payments are exchanged at set intervals based on the currency received.
4.  **Periodic Exchanges**: If structured, periodic principal exchanges may take place to manage exchange rate fluctuations.
5.  **Final Exchange**: At maturity, principal amounts are re-exchanged at the initial rate.
6.  **Settlement**: Any remaining obligations, including adjusting for market changes, are settled, and the swap ends.

It's worth noting that variations exist depending on the specific needs of the parties involved and market conditions. Some swaps may also include options for early termination or restructuring.  

## Understanding the Risks of Currency Swaps

Like any speculative financial transaction, currency swaps come with several risks. These risks can be mitigated but not completely eliminated by the participants.

### Counterparty Risk

This is the risk that one of the parties involved in the swap may default on their obligations, leaving the other party exposed to potential financial loss. [Counterparty risk](https://www.investopedia.com/terms/c/counterpartyrisk.asp) is mitigated by dealing with reputable financial institutions and using collateral or credit support annexes.

### Exchange Rate Risk

If the swap involves netting payments in a single currency, changes in the exchange rate can affect the net amount payable. If not properly managed, this could lead to unexpected costs.

### Interest Rate Risk

Fluctuations in interest rates can affect the value of the swap, especially if one leg of the swap has a floating interest rate. Companies should carefully [manage interest rate risk](https://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp) to avoid adverse effects on their financial positions.

### Liquidity Risk

If one party needs to exit the swap before its maturity, there may be a lack of liquidity, making it difficult or expensive to unwind the position.

### Valuation

The complexity of currency swaps can make them difficult to value, particularly if they involve less active currencies or complex structures. This can lead to inaccuracies in financial reporting or challenges in managing the swap’s performance over time.

## Comparing Currency Swaps to Forex and Interest Rate Swaps

Currency swaps are sometimes confused with foreign exchange ([forex](https://www.investopedia.com/best-brokers-for-forex-trading-4587882) or FX) swaps or [interest rate swaps](https://www.investopedia.com/terms/i/interestrateswap.asp). While currency swaps share elements with those trades, there are fundamental differences between them.  

### Duration

Forex swaps are primarily used for short-term liquidity management; they typically last less than a year. Currency swaps are medium-to-long-term and can span several years. This longer duration allows them to serve broader strategic purposes, such as hedging against more enduring exchange rate fluctuations or gaining access to foreign capital markets.

### Stages

FX swaps involve a simple exchange of principal amounts at the beginning and end of the contract. Currency swaps often include periodic exchanges of interest payments in different currencies during the life of the agreement.

### Number of Currencies

Interest rate swaps are done with a single currency and focus on managing interest rate risk. Currency swaps introduce a bit more complexity by involving two currencies. This means that currency swaps must account for interest rate differentials and exchange rate changes.  

### Principal and Interest Payments

Currency swaps differ from FX swaps and interest rate swaps since they involve the exchange of both principal and interest payments in different currencies over a longer term. Forex swaps are short-term currency exchanges without interest payments, while interest rate swaps involve exchanging interest payments in the same currency without principal exchange.

Interest rate swaps use a notional principal to calculate interest, while currency swaps often exchange the principal amounts. This makes currency swaps a more comprehensive tool for managing currency and interest rate exposures simultaneously.

## Practical Example of a Currency Swap

Suppose that a U.S. company has taken out a five-year, $10 million loan at a fixed interest rate of 3% in USD (U.S. dollars). Meanwhile, a Japanese company has a five-year, ¥1 billion loan at a fixed interest rate of 1% in JPY (Japanese yen). The exchange rate between the two currencies is 1 USD = 100 JPY.

Both companies want to manage their currency risk and benefit from each other's loan terms. Unlike foreign exchange transactions, currency swaps don't have to involve the actual exchange of principal amounts. Instead, the principal amounts can be [notional](https://www.investopedia.com/terms/n/notionalvalue.asp) and serve as the basis for calculating the interest payments.  

Here's what's agreed:

1.  The U.S. company's notional amount is $10 million.
2.  The Japanese company's notional amount is ¥1 billion (equivalent to $10 million at the hypothetical exchange rate)
3.  The U.S. company agrees to pay 1% interest on ¥1 billion to the Japanese company.
4.  The Japanese company agrees to pay 3% interest on $10 million to the U.S. company.  
    

For each of the five years of the swap, the U.S. company pays 1% × ¥1 billion = ¥10 million. In return, the Japanese company pays 3% × $10 million = $300,000 each year.

Payments can be made directly in each currency or netted and converted to one currency at the current exchange rate. For example, if the exchange rate when an interest payment is made is 1 USD = 100 JPY (using a round figure to make the calculations below easy to follow), then:

*   ¥10 million would be equivalent to approximately $100,000.
*   The net payment would then be $300,000 - $100,000 = $200,000, which the Japanese company would pay to the U.S. company.
*   This process repeats each year for the duration of the swap.

When the swap period ends after five years, the contract terminates, and there is no exchange of the principal amounts since they were only notional and used for calculating the interest payments. Each company remains responsible for its original loan in its respective currency.  

The swap allows each company to match its loan obligations to its income currency. The U.S. firm effectively turns its dollar-denominated loan into a yen-denominated one, which could be beneficial if it has yen income from Japanese operations. The Japanese company does the opposite. If the U.S. company can't access the Japanese credit market directly (or vice versa), this swap allows it to benefit indirectly from the lower Japanese interest rates.

## Variations in Interest Rate Exchanges in Currency Swaps

Interest rate exchanges come in three forms:

*   fixed rate to fixed rate
*   floating rate to floating rate
*   fixed rate to floating rate

In a swap between euros and dollars, a party with an initial obligation to pay a fixed interest rate on a loan in euros can exchange that for a fixed interest rate in dollars or 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](https://www.investopedia.com/terms/b/basisrateswap.asp).

Interest rate payments are usually calculated quarterly and exchanged semiannually, although swaps can be structured as needed. Interest payments are generally not netted because they are in different currencies. If the interest payments were netted, it would mean that instead of each party making separate interest payments to the other, they would calculate the difference between what they owe each other. Only the party owing more would make a payment to make up the difference.  

## How Do Currency Swaps Differ From Currency Forwards or Futures?

[Futures](https://www.investopedia.com/terms/f/futures.asp) and forwards are derivative contracts that give counterparties the right to fix an exchange rate today to be executed at a future date. Swaps instead involve a series of payments over time. In general, swaps are used for longer-term strategic financial management, while forwards and futures are more commonly used for shorter-term hedging or speculative purposes.

## What Is SOFR?

The secured overnight financing rate, or [SOFR](https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954), is a benchmark interest rate designed to be a more robust and transparent alternative to the London Interbank Offered Rate (better known as LIBOR). The phase-out of the LIBOR began after a series of manipulation scandals in the early 2020s.

## How Is SOFR Calculated?

SOFR is based on transactions in the U.S. Treasury [repurchase](https://www.investopedia.com/terms/r/repurchaseagreement.asp) (repo) market, where banks and investors borrow or lend Treasurys overnight. The New York Federal Reserve calculates and publishes SOFR each business day, based on the previous day's trading activity.

## The Bottom Line

Currency swaps are financial agreements where two parties exchange principal and interest in different currencies, facilitating operations across borders. These swaps serve as essential tools for multinationals and financial institutions to hedge against exchange rate fluctuations and manage foreign currency exposure.

The structured interest payments can follow fixed or floating rates, providing flexibility in financial management. At maturity, the swap often involves re-exchanging principal amounts, highlighting the significance of exchange rate risk management.

Unlike simple forex or interest rate swaps, currency swaps offer comprehensive financial solutions by involving both principal and interest exchanges. Companies can leverage currency swaps to access favorable borrowing rates and mitigate global financial risks effectively.  

> **Article Sources**
>
> 1.  Bank for International Settlements. "[Triennial Central Bank Survey, 2022](https://www.bis.org/statistics/rpfx22_fx.htm)."
>     
> 2.  Bank for International Settlements. ["The Basic Mechanics of FX Swaps and Cross-Currency Basis Swaps](https://www.bis.org/publ/qtrpdf/r_qt0803z.htm)."
>     
> 3.  S.K. Parameswaran. "[Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives](https://onlinelibrary.wiley.com/doi/book/10.1002/9781119816621)," Page 427. John Wiley & Sons, 2022.
>     
> 4.  S.K. Parameswaran. "[Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives](https://onlinelibrary.wiley.com/doi/book/10.1002/9781119816621)," Pages 411-432. John Wiley & Sons, 2022.
>     
> 5.  Federal Reserve Bank of New York. "[Secured Overnight Financing Rate Data](https://www.newyorkfed.org/markets/reference-rates/sofr)."