What Is a Foreign Currency Swap?

A foreign currency exchange, or foreign currency swap, involves two parties exchanging interest payments on a loan in one currency for another.

You can exchange the principal in a foreign currency swap. The agreement would return this. Most trades utilize the principal solely for calculating interest and do not transfer it.

The Foreign Currency Swap

Engaging in a currency exchange can provide loans in foreign currency at better interest rates than borrowing directly in a foreign market.

During the 2008 financial crisis, the Federal Reserve offered currency swaps to developing nations with liquidity issues for borrowing reasons.

Salomon Brothers conducted the first currency swap between the World Bank and IBM 1981. IBM traded Deutsche Marks and Swiss francs with the World Bank for U.S. dollars.

Borrowers can arrange foreign currency swaps for loans with a 10-year maturity. Currency swaps vary from interest rate swaps by including principal exchanges.

Foreign Currency Swap Process

A foreign currency exchange requires each party to pay interest on the other’s loan principle during the arrangement. After the swap, code amounts are swapped again at the agreed rate to prevent transaction risk or the spot rate.

Currency swaps are linked to the London Interbank Offered Rate (LIBOR). The average interest rate international banks use to borrow is LIBOR. International borrowers use it as a benchmark.

SOFR will replace LIBOR for benchmarking in 2023. By 2021, no new U.S. dollar transactions will use LIBOR (although it will continue to offer rates for existing agreements).

Types of Swaps

Currency exchanges fall into two categories. A fixed-for-fixed-rate currency swap exchanges fixed interest payments in one currency for another.

For the fixed-for-floating rate swap, fixed interest payments in one currency are swapped for floating interest payments in another. No loan principle is changed in this swap.

Foreign currency swaps move capital to boost economic activity. These swaps provide governments and corporations with lower-cost financing. They can also shield assets from currency rate risk.

Why Use Currency Swaps?

Lowering Loan Costs

Currency swaps are often used to lower debt. Say European Company A borrows $120 million from U.S. Company B. U.S. Company A borrows 100 million euros from European Company A.

They trade at a LIBOR-indexed $1.2 spot rate. The two corporations made the arrangement because it offers favorable currency borrowing rates.

The principal exchanged in a currency swap contract will be repeated at maturity.

Lowering Exchange Rate Risks

Additionally, some organizations employ currency swaps to hedge against exchange rate swings. Companies doing business abroad face currency rate concerns.

They can mitigate such risks by holding opposing and simultaneous currency bets. U.S. Company A and Swiss Company B can hedge their currencies by swapping Swiss francs and USD.

After the hedge is no longer needed, they can unroll the swap. If shifting currency rates hurts their firm, the swap profit can counterbalance that.

Why do companies swap foreign currency?

Forex swaps provide two fundamental goals. They provide companies with foreign currency loans at lower rates than local banks. They also help companies hedge foreign exchange risks.

What are the foreign currency swap types?

Foreign currency swaps exchange fixed-rate currency interest payments. One party may trade a fixed-rate interest payment for the other’s floating-rate payment. Both parties may exchange floating-rate interest payments in a swap arrangement.

When did the first foreign currency swap occur?

The World Bank and IBM Corporation reportedly conducted the first foreign currency exchange in 1981.

Conclusion

• A foreign currency exchange involves two parties swapping interest rate payments on their loans in different currencies.
• The deal can also exchange loan principals.
• Fixed-for-fixed and fixed-for-floating rate swaps are the primary types.
• Foreign currency swaps can let enterprises borrow cheaper than local banks.
• They can also safeguard an investment from currency rate changes.