A Currency Swap is a swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on the balance sheet.
A currency swap is a foreign-exchange agreement between two parties to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap.
Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Currency swaps were originally done to get around exchange controls.
Uses
Currency swaps have two main uses:
- To secure cheaper debt.
- To hedge against exchange rate fluctuations.
Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.
There are three different ways in which currency swaps can exchange loans:
The most simple currency swap structure is to exchange the principal only with the counterparty, at a rate agreed now, at some specified point in the future. Such an agreement performs a function equivalent to a forward contract or futures.
Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty because they are denominated in different currencies. As each party effectively borrows on the other’s behalf, this type of swap is also known as a back-to-back loan.
Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted.
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.