Foreign Currency (FX) Swap: Definition, How It Works, and Types

What Is a Foreign Currency Swap?

A foreign currency swap is an agreement between two foreign parties to swap interest payments on a loan made in one currency for interest payments on a loan made in another currency.

A foreign currency swap can involve exchanging principal, as well. This would be exchanged back when the agreement ends. Usually, though, a swap involves notional principal that's just used to calculate interest and isn't actually exchanged.

Understanding Foreign Currency Swaps

One purpose of engaging in a currency swap is to procure loans in foreign currency at more favorable interest rates than might be available borrowing directly in a foreign market.

During the financial crisis in 2008, the Federal Reserve allowed several developing countries that faced liquidity problems the option of a currency swap for borrowing purposes.

In a transaction arranged by investment banking firm, Salomon Brothers, the World Bank entered into the very first currency swap in 1981 with IBM. IBM swapped German Deutsche marks and Swiss francs to the World Bank for U.S. dollars.

Foreign currency swaps can be arranged for loans with maturities as long as 10 years. Currency swaps differ from interest rate swaps in that they can also involve principal exchanges.

The Process of a Foreign Currency Swap

In a foreign currency swap, each party to the agreement pays interest on the the other's loan principal amounts throughout the length of the agreement. When the swap is over, if principal amounts were exchanged, they are exchanged once more at the agreed upon rate (which would avoid transaction risk) or the spot rate.

Currency swaps have been tied to the London Interbank Offered Rate (LIBOR). LIBOR is the average interest rate that international banks use when borrowing from one another. It has been used as a benchmark for other international borrowers.

However, in 2023, the Secured Overnight Financing Rate (SOFR) will officially replace LIBOR for benchmarking purposes. In fact, as of the end of 2021, no new transactions in U.S. dollars use LIBOR (although it will continue to quote rates for the benefit of already existing agreements).

Types of Swaps

There are two main types of currency swaps. The fixed-for-fixed rate currency swap involves exchanging fixed interest payments in one currency for fixed interest payments in another.

In the fixed-for-floating rate swap, fixed interest payments in one currency are exchanged for floating interest payments in another. In this type of swap, the principal amount of the underlying loan is not exchanged.

Reasons for Using Currency Swaps

Decreasing Borrowing Costs

A common reason to employ a currency swap is to secure cheaper debt. For example, say that European Company A borrows $120 million from U.S. Company B. Concurrently, U.S Company A borrows 100 million euros from European Company A.

The exchange between them is based on a $1.2 spot rate, indexed to LIBOR. The two companies make the deal because it allows them to borrow the respective currencies at a favorable rate.

If a currency swap deal involves the exchange of principal, that principal will be exchanged again at the maturity of the agreement.

Reducing Exchange Rate Risks

In addition, some institutions use currency swaps to reduce exposure to anticipated fluctuations in exchange rates. For instance, companies are exposed to exchange rate risks when they conduct business internationally.

Therefore, it can behoove them to hedge those risks by essentially taking opposite and simultaneous positions in the currency. U.S. Company A and Swiss Company B can take a position in each other’s currencies (Swiss francs and USD, respectively) via a currency swap for hedging purposes.

Then, they can unfold the swap later when the hedge is no longer needed. If they suffered a loss due to fluctuating exchange rates affecting their business activity, the profit on the swap can offset that.