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What is a Currency Swap and How Does it Work?

In the world of finance and trading, a currency swap also goes by the name ‘cross-currency swap’, since you are exchanging one currency for another in the transaction. It is a legal contract between 2 parties, with the pre-stated objective of exchanging the currencies at a future date, at a pre-set rate of exchange. Typically, global banks are the facilitators of these swaps a.k.a. the middlemen, in currency swap exchanges. It is also possible for global banks to function as counterparties in currency swaps. This is a great way to hedge against their global exposure, particularly as it relates to forex risk.

What does swap mean? In finance, a currency swap is an agreement between 2 counterparties to a forex transaction. They agree to exchange one currency for another, at a specific point in time. The financial instruments can be anything, but the majority of swaps involve forex exchanges.

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What are the Benefits of Currency Swaps?

Currency swaps are universally accepted as a convenient legal contract in finance. These currency swaps allow loans to be redenominated, and they make it easy to understand how one currency must be paid for in terms of another currency.

The benefits of swaps are enjoyed by individuals and companies alike. For one thing, swaps allow greater flexibility to hedge against the attendant risk of cross-currency exchange rates. Plus, there’s the added benefit of locking in a fixed exchange rate for a much longer period of time. That way, you can budget accordingly, and hedge against the uncertainty of volatile markets.

Large multinational corporations routinely make use of currency swaps, given the many advantages they offer. For one thing, swaps make it easy to raise funds in one currency and generate savings in another currency. There are minimal risks associated with swap trading. Additionally, currency swaps are highly liquid, and both parties to the transaction are able to settle on an agreement at any point during the lifespan of the currency swap transaction. Parties to a currency swap are able to terminate the financial transaction prior to its designated date, through a negotiated settlement.

Swap Trading: Practical Examples

Years ago, swap trading was conducted expressly to bypass government-sanctioned exchange rate controls. Nowadays, currency swaps are performed as part of a hedging strategy against FX fluctuations. Swaps are also used to lower the interest rate exposure of parties to the transaction, or simply to obtain cheaper debt. As an example, assume that a US-based corporation ABC wants to expand into the UK. At the same time, assume that a UK-based corporation DEF wants to enter the US market. These international companies operate in the US and the UK respectively, and as such are unlikely to be offered competitive loans by banks and financial institutions.

As a case in point, UK banking institutions offer company DEF a loan at 12%. US banking institutions may offer company ABC loans at 13%. However, both of these companies may have a competitive advantage in the domestic markets where they can get loans at 8%. The next step is where things get really interesting! Company ABC in the US could swap loans with company DEF in the UK at 8%. Both of these companies could effectively pay one another’s interest obligations on their debt. In the case of loan differentials, currency swaps are still possible. Companies ABC and DEF simply negotiate a formula that reflects their respective swap trading obligations with one another.

There is another option available. Company ABC and company DEF could tackle the forex swap by issuing bonds at underlying interest rates. These companies would then deliver the bonds to the swap bank. The swap bank will then switch them over to one another.

In this example, company ABC will have assets in the United Kingdom, while company DEF will have assets in the United States. The interest generated from company ABC will be paid through the swap bank and delivered to company DEF, and vice versa. This is an example of a currency swap with different interest rates in action. At maturity, each of the companies will pay the principal amount to the swap bank, and they will receive the original principal in return. In both cases, company ABC, and company DEF has the forex they desire, at a much cheaper interest rate, while also protecting themselves against forex risk.

Lesser Known Use Cases of Cross Currency Swaps

Emerging Market Debt Hedging

  • Scenario: EM corporates borrow in hard currencies (USD or EUR) but earn revenues in local currency.
  • Use Case: Currency swaps to convert their foreign currency obligations into local currency to reduce FX risk.
  • Example: A Brazilian exporter issuing USD bonds may swap obligations into BRL to match local operating cash flows.

Infrastructure Financing in Developing Countries

  • Scenario: Development banks (e.g., African Development Bank, Asian Development Bank) might use currency swaps to offer more favorable local currency loans for infrastructure projects.
  • Mechanism: The development bank issues USD or EUR-denominated debt (lower rates) and then swaps into local currency to provide local currency financing to the project sponsor.

Unconventional Hedging Strategies

  • Carry Trade Enhancement: Investors sometimes use currency swaps to capture interest rate differentials between two currencies, beyond a standard forward or futures contract.
  • Cross-Border M&A Funding: A company acquiring a foreign target might use swaps to lock in a certain exchange rate for the deal’s financing structure.

Real-World Examples of Currency Swaps

IBM–World Bank Swap (1981)

  • Overview: Often cited as one of the earliest modern currency swaps. IBM had debt denominated in Swiss francs and German marks, while the World Bank needed USD funding. They effectively exchanged payment obligations, achieving more favorable interest and currency terms than if each had gone to the market independently.
  • Significance: Demonstrated how two parties with complementary needs could reduce borrowing costs via a currency swap.

Federal Reserve Central Bank Swap Lines (2007–2009; 2020)

  • Overview: During the 2008 Global Financial Crisis and again in March 2020 (COVID-19 pandemic onset), the Federal Reserve established temporary USD swap lines with several central banks (e.g., ECB, BoJ, BoE, SNB) to ease USD funding pressures globally.
  • Mechanics: The Fed provided USD to these central banks in exchange for their local currency, which was swapped back at maturity at the same exchange rate, plus interest.
  • Impact: Helped stabilise global dollar funding markets and reduce volatility.

China’s Renminbi Swap Agreements

  • Overview: The People’s Bank of China (PBoC) has entered into multiple bilateral currency swap arrangements with countries such as Argentina, Indonesia, and Russia.
  • Rationale: Facilitates trade settlement in local currencies, reduces dependence on the USD, and promotes internationalization of the RMB.

Corporate Hedging Examples

  • Apple Inc. (Various Years): Uses currency swaps to hedge exposures in EUR, GBP, JPY, etc., given its global sales distribution.
  • Toyota Motor Corporation (2015): Entered into cross-currency swaps to manage interest costs on USD-denominated bonds while keeping net exposure in JPY.

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Currency Swap main FAQs

  • What is the purpose of a currency swap?

    In the case of swaps being made by businesses and institutions, the reason currency swaps are done is typical as a hedge, or as a way to get cheaper financing. In the investing world, a currency swap might be sought after by buying a high-yielding currency such as the Australian dollar, while simultaneously selling a low-yielding currency like the Japanese Yen. So long as the movement in the pair is flat or advantageous to the trader, they can continue holding the pair while also collecting the swap or the difference in interest rates between the two currencies.

  • What’s the greatest advantage of currency swaps for investors?

    While using a currency swap as a way to generate income can be useful, the greatest advantage of a currency swap for retail investors is the ability to hedge against volatility in the currency markets. With a currency swap an investor can reduce the volatility in their overseas holdings, thus improving their risk-return profile and smoothing out the ups and downs in their portfolio. Because currency rates are always changing currency swaps can help to smooth out profits and losses in any portfolio.

  • What are the potential downsides to currency swaps?

    There are a few negatives that can also be associated with currency swaps. In the case of an investor hedging their position, any positive movement in the currency will be muted in the results of the investment because the hedge is protecting from volatility in both directions. Those holding a position to collect the swap (such as AUD/JPY) could get wiped out by a sudden adverse movement in the currency pair. In the case of businesses doing swaps, there is a credit and interest rate risk, particularly with swaps that stretch over several years.