Foreign Currency Swap: Definition, Mechanism, and Types
What Is a Forex Swap?
A foreign currency swap is an agreement between two foreign parties to exchange interest payments on one currency’s loan for interest payments on another currency’s loan.
A foreign currency swap might also involve the exchange of principle. When the agreement expires, this will be returned. However, most swaps include notional principle that are only utilized to calculate interest and are not actually traded.
Foreign Currency Swaps Explained
One reason for engaging in a currency swap is to obtain loans in foreign currency at lower interest rates than would be available if borrowed directly in a foreign market.
During the 2008 financial crisis, the Federal Reserve gave numerous developing countries with liquidity issues the option of borrowing through a currency exchange.
In 1981, the World Bank embarked into the first currency swap with IBM, brokered by investment banking company Salomon Brothers. IBM exchanged German Deutsche marks and Swiss francs for US dollars with the World Bank.
For loans with durations of up to ten years, foreign currency swaps can be negotiated. Currency swaps differ from interest rate swaps in that principle exchanges can occur.
The Foreign Currency Swap Procedure
In a foreign currency swap, each party pays interest on the principle amounts of the other party’s loans for the duration of the agreement. If primary amounts were swapped during the swap, they are exchanged again at the agreed-upon rate (which eliminates transaction risk) or the current rate.
Currency swaps have historically been linked to the London Interbank Offered Rate (LIBOR). LIBOR is the average interest rate used by multinational banks when lending to one another. It has served as a model for other international debtors.
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The Secured Overnight Financing Rate (SOFR) will, however, officially replace LIBOR for benchmarking purposes in 2023. In fact, no new transactions in US dollars will use LIBOR as of the end of 2021 (though it will continue to provide rates for the benefit of existing agreements).
Types of Swaps
Currency swaps are classified into two types. Exchanging fixed interest payments in one currency for fixed interest payments in another is what a fixed-for-fixed-rate currency swap entail.
Fixed interest payments in one currency are swapped for floating interest payments in another in a fixed-for-floating rate swap. The principal amount of the underlying loan is not exchanged in this form of swap.
Reasons to Use Currency Swaps to Reduce Borrowing Costs
A common rationale for using a currency exchange is to get lower-cost debt. Assume European Company A borrows $120 million from American Company B. At the same time, American Company A borrows 100 million euros from European Company A.
The exchange rate is based on a $1.2 spot rate that is tied to LIBOR. The two corporations agree to the transaction because it allows them to borrow their respective currencies at a lower interest rate.
If a currency swap transaction involves the exchange of principal, that principle will be swapped again at the agreement’s maturity.
Exchange Rate Risk Reduction
Furthermore, some institutions employ currency swaps to decrease their exposure to expected exchange rate changes. Companies, for example, face exchange rate risks while conducting overseas business.
As a result, it may be advantageous for them to hedge those risks by taking opposite and simultaneous bets in the currency. For hedging purposes, U.S. Company A and Swiss Company B can take positions in each other’s currencies (Swiss francs and USD, respectively) through a currency swap.
They can then unroll the swap when the hedge is no longer required. If they sustained a loss because of fluctuating currency rates hurting their business, the earnings from the swap can compensate.
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