Currency Swap: Definition, Mechanics, and Practical Applications

A currency swap, also known as a cross-currency swap, is a financial agreement where parties exchange interest—and sometimes principal—in one currency for the equivalent in another currency. These swaps were initially employed to bypass exchange controls but are now primarily utilized to hedge long-term investments and alter interest rate exposure between parties.

For companies operating internationally, currency swaps provide a means to secure more favorable loan rates in the local currency compared to borrowing from local banks. Notably, while these transactions are crucial in financial markets, they aren’t mandated to be disclosed on a company’s balance sheet.

Banks, investors, and multinational corporations frequently use these financial instruments because they are essential to managing the risk associated with fluctuating exchange rates and interest rates.

At the outset, parties agree on whether to exchange the principal amounts of the two currencies. This creates an implied exchange rate, but at maturity, the same principal amounts are exchanged, exposing parties to market fluctuations. Pricing is often expressed using LIBOR rates, though this benchmark is being phased out in favor of SOFR.

Currency swaps can vary in execution; while some utilize notional principal amounts for interest calculation without actual exchange, others involve a full exchange of principal that’s reversed at maturity. These swaps offer flexible maturities of at least 10 years, with adjustable fixed or floating interest rates.

Notably, bilateral agreements between countries, like the $75 billion swap between India and Japan in 2018, aim to stabilize forex and capital markets.

Interest rate exchanges in currency swaps can occur in three forms: fixed rate to fixed rate, floating rate to floating rate, or fixed rate to floating rate. For instance, parties can swap fixed interest rates between euros and dollars or exchange floating rates. Quarterly calculations and semi-annual exchanges are common, though structures can be customized.

Currency swaps serve to manage exchange rate risks and secure more favorable loan rates when conducting business internationally.

Interest rate exchanges can be fixed rate to fixed rate, floating rate to floating rate, or fixed rate to floating rate.

Currency swap maturities are negotiable for at least 10 years, offering flexibility to the parties involved.