Currency Swap: What is it and how to work with it?

A currency swap is a financial product in which two counterparties agree to mutually exchange the performance of two assets. In a currency swap, one party can exchange interest payments in its own currency for interest payments in another currency, for example. This allows to manage the risks associated with exchange rate fluctuations. This instrument is often used by companies and banks to optimise their financial flows and protect themselves from changes in the currency markets. Let's understand in detail what a swap is and how to work with it.

What is a currency swap?

A swap is a contract in which counterparties, most often banks or financial institutions, exchange one cash flow for another on predetermined terms and at a set time. The value of such a swap usually depends on the value of the underlying assets, be it stocks, commodities, currencies or interest rates. A currency swap, or Forex swap, is a contract in which the parties exchange interest payments in two different currencies for a set period of time, according to the terms specified in the agreement.

Here is what this swap often involves:

• An initial exchange of principal in two different currencies;
• Regular interest payments in each currency;
• A final exchange of principal at the end of the contract term.

History and features of swap contracts

Currency swaps have their historical roots in the 1960s, when the US Federal Reserve (Fed) conducted an operation to stabilise the dollar by exchanging it for German marks with the Bundesbank. In this agreement, the Fed stipulated that the reverse transaction, that is, the return of the marks and dollars, would take place on a predetermined date, illustrating how swaps began to be used to manage currency risk. The first real currency swap was entered into in 1981 between IBM and the World Bank, where IBM required Swiss francs and German marks and the World Bank required US dollars. Since the 1990s, the swap market grew rapidly and by 2000, new, more complex types of swaps had emerged.

Swaps have become universal instruments used for risk management and speculation in the markets for currencies, interest rates, equities and commodities. To be fully effective, a swap contract must include key elements:

• Schedule: The dates on which cash flows are exchanged;
• Duration: The total period of the contract;
• Start Date: When the swap becomes effective;
• Fixed Rate Value (if applicable);
• Nature of Underlying Asset: The asset or index on which the swap is based;
• Nominal Amount: Value for calculating flows;
• Basis of Calculation: Method for calculating interest or payments;
• Reference to variable rate (if applicable): Index for variable payments.

These components ensure that the terms and obligations of the parties are precisely defined, making swaps flexible for a variety of purposes, from hedging to speculation.

How does a currency swap work?

A currency swap is an agreement in which two parties exchange a principal amount in different currencies at a current rate. During the term of the contract, they periodically exchange interest payments on the amounts borrowed, with the principal remaining unchanged. At the end of the contract term, the principal is exchanged back at the originally agreed exchange rate, which helps participants manage exchange rate risks and optimise foreign currency financing.

An example is when company A wants a fixed-rate loan but only has access to a variable rate. At the same time, company B is interested in a variable rate, but its bank offers only a fixed rate. The solution for both companies is a swap, where they exchange interest obligations: company A starts paying the fixed rate and company B pays the variable rate, allowing both parties to get the terms they want.

Swap in Forex trading

A currency swap, or FX swap, is an agreement to simultaneously borrow one currency and lend another on an initial date and then exchange the amounts at maturity. Such a swap involves two simultaneous transactions: at the beginning, one party borrows one currency and simultaneously lends another. At maturity, both parties reverse the transaction by exchanging the original amounts again, which serves as a mutual guarantee of repayment. This mechanism provides both parties with protection from currency risks and flexibility in managing funds.

At the Forex market, traders use currency swaps as part of a long-term ‘carry trade’ strategy, where profits depend on the difference in interest rates of currencies. To do this, they choose currency pairs with the most different rates, buying the currency with the higher yield. It is important for traders to closely monitor changes in exchange rates, as well as take into account brokerage commissions when holding positions overnight or for a long period of time. This strategy requires constant monitoring in order to adjust positions and manage risk in a timely manner.

Different types of swaps

Depending on the basis used in swaps, this financial product can be divided into several categories. Below we look at the main types of swaps that are used in the financial markets:

• Interest Rate Swaps: Interest Rate Swaps (IRS) are used to exchange the income from a fixed rate bond for the income from a variable or floating rate bond. In this swap, the principal amount remains unchanged and the parties exchange only interest payments. Such swaps help hedge the risks associated with changes in interest rates;
• Currency Swap: A currency swap (C.I.R.S.) exchanges interest and principal in one currency for an equivalent in another currency. This type of swap manages currency risk because payments are linked to rates in different currencies. Counterparties agree to exchange interest and return the original currency at the end of the term;
• Credit Default Swaps (CDS): Credit default swaps are used to protect against the default risk of a bond issuer. Under this agreement, the buyer of the swap pays a premium and the issuer assumes the loss in the event of default. This type of swap resembles an insurance policy and is used to hedge credit risk;
• Commodity swaps: Commodity swaps are agreements tied to the price of a specific commodity, such as oil or natural gas. In such swaps, one party accepts payments at a fixed price, protecting themselves from fluctuations in commodity prices. These swaps are useful for stabilising commodity prices in long-term contracts.

There are other types of swaps that are more specialised, such as:

• Basis swap: Used to exchange two variable rates indexed to short-term rates in one or two different currencies;
• Constant Maturity Interest Rate Swap: Used to exchange one variable rate indexed to short-term interest rates for another variable rate indexed to medium or long-term interest rates;
• Asset swap: Represents a combination of an interest rate swap and a fixed rate bond to create a synthetic floating rate bond;
• Total Return Swap: Exchanges the return and risk of changes in the value of two different assets over a specified period of time;
• Inflation swap: Exchange a fixed or floating rate for an inflation rate;
• Equity swaps: Work the same way as interest rate swaps;
• Curve Swap: A single-currency interest rate swap (variable rate versus variable rate) based on the shape of the yield curve.

Conclusion: Dealing with currency swaps

Currency swaps are complex financial instruments used by professional investors to hedge and speculate in the international currency market. They not only help to manage cash flows and optimise credit, but also serve as an effective means of protecting against adverse currency fluctuations and obtaining better foreign currency financing. However, the use of swaps requires careful analysis and understanding, as mistakes can lead to significant losses if one party defaults.

While currency swaps can offer long-term benefits and protection, they also come with certain complexities, such as high set-up and management costs, as well as potential difficulties with early exit from the contract. Therefore, retail investors are advised to carefully consider the mechanisms and potential risks of swaps before including them in their portfolio.