While the idea of a swap by definition normally refers to a simple exchange of property or assets between parties, a currency swap also involves the conditions determining the relative value of the assets involved.
That includes the exchange rate value of each currency and the interest rate environment of the countries that have issued them. In a currency swap operation, also known as a cross currency swap, the parties involved agree under contract to exchange the following: Currency swaps are often used to exchange fixed-interest rate payments on debt for floating-rate payments; that is, debt in which payments can vary with the upward or downward movement of interest rates.
However, they can also be used for fixed rate-for-fixed rate and floating rate-for-floating rate transactions. In a typical currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received.
Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another. Throughout the length of the contract, the European company would periodically receive an interest payment in euros from its counterparty at Libor plus a basis swap price, and it would pay the American company in dollars at the Libor rate.
The benefits for a participant in such an operation may include obtaining financing at a lower interest rate than available in the local market, and locking in a predetermined exchange rate for servicing a debt obligation in a foreign currency. Currency swaps were first developed by financial institutions in the UK in the s as a manner to circumvent currency controls imposed at that time by the government.
The swap market was launched on a more formal basis in , in a transaction in which the World Bank sought to reduce its interest rate exposure by borrowing dollars in the US market and exchanging them for Swiss franc and Deutsche mark debt obligations held by IBM. Given the nature of each, FX swaps are commonly used to offset exchange rate risk, while cross currency swaps can be used to offset both exchange rate and interest rate risk.
Cross currency swaps are frequently used by financial institutions and multinational corporations for funding foreign currency investments, and can range in duration from one year to up to 30 years.
FX swaps are typically used by exporters and importers, and institutional investors that seek to hedge their positions. Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
High risk investment notice: Leverage can work against you. Due to the certain restrictions imposed by the local law and regulation, German resident retail client s could sustain a total loss of deposited funds but are not subject to subsequent payment obligations beyond the deposited funds. Be aware and fully understand all risks associated with the market and trading. Limited, any affiliates of aforementioned firms, or other firms within the FXCM group of companies [collectively the "FXCM Group"], carefully consider your financial situation and experience level.
The FXCM Group may provide general commentary which is not intended as investment advice and must not be construed as such. Seek advice from a separate financial advisor. The FXCM Group assumes no liability for errors, inaccuracies or omissions; does not warrant the accuracy, completeness of information, text, graphics, links or other items contained within these materials.
Registered in England and Wales with Companies House company number How Do Currency Swaps Work? As its name implies, a currency swap is the exchange of currencies between two parties. A Two-way Exchange In a currency swap operation, also known as a cross currency swap, the parties involved agree under contract to exchange the following: Comparative Advantage The benefits for a participant in such an operation may include obtaining financing at a lower interest rate than available in the local market, and locking in a predetermined exchange rate for servicing a debt obligation in a foreign currency.
Past Performance is not an indicator of future results. Retrieved 11 September http:More...