Currency Swap

Explained:

A currency swap is a form of swap. It is most easily understood by comparison with an interest rate swap. An interest rate swap is a contract to exchange cash flow streams that might be associated with some fixed income obligations—say swapping the cash flows of a fixed rate loan for those of a floating rate loan. A currency swap is exactly the same thing except, with an interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are in different currencies.

That difference has a practical consequence. With an interest rate swap, cash flows occurring on concurrent dates are netted. With a currency swap, the cash flows are in different currencies, so they can't net. Full principal and interest payments are exchanged without any form of netting.

Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter into a currency swap to exchange the cash flows associated with

a five-year USD 100MM loan at 6-month USD Libor, and

a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.

All cash flows associated with those loans are paid:

initial receipt/payment of loaned principal,

payment/receipt of interest (in the same currency) on that loan,

ultimate return/recovery of the principal at the end of the loan.

Vanilla currency swaps are quoted both for fixed-floating and floating-floating (basis swap) structures. Fixed-floating swaps are quoted with the interest rate payable on the fixed side—just like a vanilla interest rate swap. The rate can either be expressed as an absolute rate or a spread over some government bond rate. The floating rate is always "flat"—no spread is applied. Floating-floating structures are quoted with a spread applied to one of the floating indexes.

Currency swaps can be used to exploit inefficiencies in international debt markets. Suppose a corporation needs an AUD 100MM loan, but US-based lenders are willing to offer more favorable terms on a USD loan. The corporation could take the USD loan and then find a third party willing to swap it into an equivalent AUD loan. In this manner, the firm would obtain its AUD loan but at more favorable terms than it would have obtained with a direct AUD loan. That advantage must, of course, be balanced against the transaction costs, pre-settlement risk and settlement risk associated with the swap. This is illustrated in Exhibit 1.

Swapping a USD Loan Into an AUD Loan
Exhibit 1

By entering into a swap with a third party, a corporation can convert an USD loan into an AUD loan.

Just as a vanilla interest rate swap is equivalent to a strip of FRA's, a vanilla fixed-floating currency swap is equivalent to a strip of currency forwards.