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As its name implies, a currency swap is the exchange of currencies between two parties.
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: the principal amount of a loan in one currency and the interest applicable on it during a specified period of time for a corresponding amount and applicable interest in a second currency.
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.
Each side in the exchange is known as a counterparty.
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.
An example of a cross currency swap for a EUR/USD transaction between a European and an American company follows:
In a cross currency basis swap, the European company would borrow US$1 billion and lend €500 million to the American company assuming a spot exchange rate of US$2 per EUR for an operation indexed to the London Interbank Rate (Libor), when the contract is initiated.
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. When the contract comes to maturity, the European company would pay US$1 billion in principal back to the American company and would receive its initial €500 million in exchange.
Types of Currency Swap Contracts
Similar to the interest rate swaps, currency swaps can be classified based on the types of leg involved in a contract. The most commonly encountered types of currency swaps include the following:
- Fixed vs. float: One leg of currency swap represents a stream of fixed interest payments while another leg is a stream of floating interest payments.
- Float vs. float (basis swap): The float vs. float swap is commonly referred to as basis swap. In a basis swap, both swaps’ legs represent floating interest payments.
- Fixed vs. fixed: Both streams of currency swap contracts involve fixed interest rate payments