What is a currency swap (plain‑English definition)
– A currency swap is a bilateral contract in which two parties agree to exchange principal amounts in different currencies and to pay each other interest on those principal amounts for a set period. At the end of the deal the original principal amounts are typically swapped back at the pre‑agreed rate. In practice the term is often used broadly to include cross‑currency swaps, where one or both interest legs are floating.
Why firms use currency swaps (short list)
– Obtain funds in a foreign currency at better terms than direct borrowing.
– Hedge long‑term currency exposure tied to assets, investments or liabilities.
– Change the currency or interest‑rate profile of existing debt without refinancing.
– Access foreign capital markets or match currency cash flows for operations.
Key features and how a typical currency swap works (step‑by‑step)
1. Agree principals and implied exchange rate.
– Example: Party A gives Currency X principal and receives Currency Y principal. The ratio defines an implicit FX rate.
2. Decide interest legs and payment frequency.
– Both legs can be fixed; one or both legs may be floating (then often called a cross‑currency swap).
3. Exchange principals (optional) at inception.
– Some structures begin with a notional exchange; others do not.
4. Make periodic interest payments in the respective currencies.
– Payments continue per the agreed schedule (quarterly, semiannual, annual).
5. Re‑exchange principals at maturity at the originally agreed rate.
– This locks the exchange rate for the life of the swap.
Numeric worked example (simple fixed‑for‑fixed)
– Terms: 3‑year swap, implied EUR/USD rate = 1.25.
– Party X receives €100,000,000 and pays $125,000,000 at start.
– Interest: Party X pays euro fixed 3.0% on €100m = €3,000,000 per year.
–