Foreign Currency (FX) Swap

What is a Foreign Currency Swap?

A foreign currency swap (also known as an “FX swap”) is a financial contract that allows two foreign parties to simultaneously exchange currencies at the current spot rate and then reverse the transaction at a specified future date and exchange rate. It essentially combines an FX spot transaction with a simultaneous forward contract, but unlike outright forwards it does not involve a net change in currency exposure over the life of the contract. This makes foreign currency swaps useful for institutions like central banks or money managers (such as hedge funds) for managing their short-term funding needs and liquidity since the “dual-leg” structure allows the parties to temporarily access foreign currency without taking on long-term exchange rate risk.

Types of Swaps

Swaps are derivative contracts in which two counterparties agree to trade sets of cash flows over a predetermined period, based on underlying financial instruments such as interest rates, currencies or commodities. Their primary use is to hedge risks, reducing the costs of borrowing or tapping markets that would be otherwise unavailable. There are three types of swaps that are most common:

• Interest rate swaps – they involve the exchange of cash flows based on different interest rate structures. This would typically be a fixed rate swapped for a floating rate
• Cross-currency swaps – this type of swap represent long-term agreements in which two parties exchange principal and interest payments in different currencies. They usually require the exchange of both the interest and principal payments over the life of the contract
• Foreign currency (FX) swaps – these are short- to medium-term instruments that involve the simultaneous spot and forward exchange of currencies

The below table provides a comparison of these three types of swaps.

Cross-currency and FX swaps are typically referred to as foreign currency swaps but are however two different types.

Reasons for Using Currency Swaps

There are various applications of foreign currency swaps that are employed by financial institutions and large corporations to manage currency-related risks and funding challenges. One primary reason for using FX swaps is to manage exchange rate risk as they allow different parties to hedge against adverse currency movements by locking in exchange rates for future transactions and also providing certainty in cash flows. This is especially important for multinational companies with revenues and expenses in multiple currencies.

Access to foreign currency funding without directly entering foreign debt markets (which can be costly or restricted) is another key reason. Through the use of foreign currency swaps, a company can essentially borrow in a foreign currency by exchanging their local currency for the needed foreign currency for a specified period and then then reversing the transaction at maturity.

Optimizing liquidity management is also a key use for foreign currency swaps. This is provided by the short- to medium term access to foreign currency funds.

When Did the First Foreign Currency Swap Occur?

The first foreign currency swap occurred in 1981 between the World Bank and IBM. The deal was arranged by the investment bank Salomon Brothers, which was one of the top five largest investment banks in the US during the ‘80s. It involved the exchange of principal and interest payments in different currencies, allowing both parties to access funding in their preferred currencies at more favourable terms. IBM swapped its obligations in Deutsche marks (DEM) and Swiss francs (CHF) for the World Bank’s US dollar (USD) obligations. This landmark deal laid the foundation for the modern cross-currency swap market.

This case study provides the parameters of the deal.

Foreign currency swaps also generate the largest turnover in the global foreign exchange markets.

How Foreign Currency Swaps Work

The way foreign currency swaps work involves a “dual-leg” structure where a “leg” refers to one set of cash flows or one part of the transaction.

Initially, the two parties exchange principal amounts in different currencies at the current spot exchange rate, which is called the “near leg”. Simultaneously, the two parties also agree to reverse the principal exchange at a specified future date and forward exchange rate, which is known as the “far leg”. Between these two legs, the parties periodically exchange interest payments (typically one is fixed and the other floating), which are calculated on the notional principal amounts in each currency. At maturity, the principal amounts are re-exchanged at the predefined forward rate.

In essence, the “near leg” provides immediate currency access, while the “far leg” ensures that the exchange is reversed, reducing uncertainty and locking in costs.

Process of a Foreign Currency Swap

Below we illustrate the process of setting up a foreign currency swap.

The different stages include:

1. The two parties agree to exchange equivalent amounts in different currencies at different points in time.
2. They decide on the terms including the amounts, exchange rates (spot and forward), interest rates, and maturity date.
3. Initiate swap (the near leg): Exchange of principal occurs at the current spot rate.
4. During the life of the contract each party pays interest to the other on the notional amount they received (typically in their domestic currency). Payments can be fixed or floating and are made at agreed intervals (for example monthly).
5. At maturity (the far leg) the original principal amounts are re-exchanged at the predetermined forward rate.

Risks Associated With Foreign Currency Swaps

Foreign currency swaps are associated with several key risks that we outline below.

• Exchange rate (or also known as “currency”) risk – this risk relates to a potential counterparty default before the far leg (maturity). In that case the other party is exposed to adverse currency movements because the final re-exchange of principal may not occur as planned.
• Counterparty risk – there could be a possibility that one party fails to make interest or principal payment, especially at maturity leading to financial loss.
• Interest rate risk – any changes in interest rates can impact the value of future cash flows. For example, rising rates may increase payment obligations for floating rates, potentially leading to increased funding costs.
• Liquidity risk – this would typically occur during volatile markets and the parties may be unable to exit the swap. Low levels of liquidity could result in unfavourable pricing or forced settlement (most likely under disadvantageous terms).
• Other risks to consider – operational, legal and regulatory risks. Swaps are complex and require accurate calculation, settlement and contract management as they work across different jurisdictions and legal standards.

Foreign Currency Swap vs. Foreign Exchange Trade

The foreign currency swap and the foreign exchange trade are both financial instruments that investors use to exchange currencies but however bear some differences.

A foreign exchange trade (also referred to as FX trade), is a one-time transaction where two parties exchange one currency for another. This is typically done at the spot market or via a forward contract (i.e. immediate or future delivery at a set rate). The transaction is simple and involves a single exchange of currencies.

On the other hand, foreign currency swaps are more complex being a two-part agreement that requires the exchange of principal amounts in two currencies at the start and the reverse exchange at a future date, with periodic interest payments in between. In addition, FX trades and FX swaps serve different purposes. FX trades are mainly for trading or payment purposes, while FX swaps are used for hedging, funding, and liquidity management.

Conclusion

To sum up, foreign currency swaps are financial instruments typically used by investors and companies to manage currency and interest rate risks, secure funding and achieve better liquidity. While exchanging principal and interest payments in different currencies provides flexibility, there are also risks such as currency and/or interest rates that investors should keep in mind.

Additional Resources

Interest Rate Swap

Exchange Rates

Foreign Exchange Markets

Equity Swaps