Currency swap: Definition and how it works

If you trade on the forex market regularly, you know that it is characterized by frequent changes in the exchange rates you are speculating on. So, you have probably also heard of currency swap. In this article, we'll give you a bit more insight to help you better understand how it works.  

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Currency swap: Definition and how it works

General definition of currency swaps:

It's an exchange of capital between two companies in two different currencies. It can also simply be a currency exchange between two parties. A currency swap also involves conditions making it possible to determine the relative value of the assets concerned, including the exchange value of each currency as well as the interest rate of the countries that issue it.

The two parties therefore agree to exchange the main amount of a loan denominated in a currency and the interest that applies to it during a specific period and against an amount equivalent to the interest applicable in the second currency. Currency swaps are often used in order to exchange fixed rate payments on a debt against variable rate payments, therefore a debt whose payment varies according to the evolution of interest rates. But these swaps can also be used for fixed rate transactions.

In a classic currency swap operation, one of the parties borrows an amount of currency from the other at the prevailing exchange rate. At the same time, it lends an amount equivalent to the counterpart's currency. During the contract, each party pays interest to the other in the currency of the principal it has received and, at the end of the contract, the two parties repay each other.

For example, imagine a currency swap between an American company and a French company. The French company borrows 1 billion dollars and lends 500 million euros to the American company with an exchange rate of two dollars per euro. During the term of the contract, the French company will regularly receive an interest payment in euros from the American company and a base price on the swap. It will pay the American company in dollars at the current exchange rate. At the end of the contract, the French company will pay back a capital of one billion dollars to the American company and receive the 500 million euros paid.

 

What is the point of a currency swap?

Firms that carry out currency swaps typically do so for securing a loan at an advantageous rate compared to the local market and to lock in a predetermined exchange rate for the service of a security claim in a foreign currency.

Currency swaps were created during the 1970s by British financial institutions in an attempt to circumvent the currency controls that were then imposed. But it was in 1981 that the swap market was launched as part of a World Bank operation to reduce its exposure to interest rates by borrowing dollars on the American markets in exchange for bonds in Swiss francs and Deutsche Marks held by IBM.

 

FX swaps and their specificities:

There is another type of swap called “FX swap” which has certain specificities. The FX swap does not offer an exchange of interest during the term of the contract but the amount of funds exchanged is different at the end of the contract. FX swaps are frequently used for the purpose of reducing currency risk while currency swaps are also used to offset currency and interest rate risks. The latter are often used by multinational companies or financial institutions in order to finance investments in foreign currencies with variable durations of up to 30 years.

FX Swaps are more often used by exporters or importers or by institutional investors seeking hedging. Their average duration varies from one day to one year. In recent years, according to statistics and surveys carried out by the BIS with central banks, it appears that FX swaps are the most frequently traded foreign exchange instruments and represent a large part of transactions carried out on currencies. The volume of trade on currency swaps is much less important with barely a quarter of the volume of FX swaps.

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67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money. Trade CFDs with eToro