A currency swap occurs when two parties agree to exchange the principal and interest of a loan in one currency for the principal and interest of a loan in another currency. The intention of the swap is to hedge against currency fluctuations by reducing the exposure to the other currency and increasing the certainty of future cash flows. An enterprise might also achieve a lower rate of interest by looking for a low-interest loan in another currency and engaging in a currency swap. The costs involved in arranging the transaction might be a disadvantage, and as with other similar transactions, there also is a risk that the other party to the swap might default.
A structure often used in a currency swap is including only the principal of the loan in the arrangement. The parties agree to swap the principal of their loans at a specified time in the future at a specified rate. Alternatively, the exchange of the principal of the loans might be combined with an interest rate swap, whereby the parties would also swap the streams of interest on the loans.
In some cases, the currency swap would relate only to the interest on the loans and not the principal. The two interest streams would be swapped over the life of the agreement. These interest streams are in different currencies, so the payments generally would be made by each party in full, rather than being netted off into one payment as might occur if only one currency is involved.
The advantage of currency swaps is that they bring together two parties who each have an advantage in a particular market. The arrangement enables each party to exploit a comparative advantage. For example, a domestic company might be able to borrow on more favorable terms than a foreign company in a particular country. It therefore would make sense for the foreign company entering that market to look for a currency swap.
Costs that might arise for an enterprise looking for a foreign currency swap include the expense of finding a willing counterparty. This might be done through the services of an intermediary or by direct negotiation with the other party. The process might be expensive in terms of fees charged by an intermediary or the cost of management time in negotiation. There also will be legal fees for drawing up the currency swap agreement.
The expenses of setting up a currency swap might make it unattractive as a hedging mechanism against currency movements in the short term. In the longer term, where there is increased risk, the swap might be cost effective in comparison with other types of derivative. A disadvantage is that, in any such arrangement, there is a risk that the other party to the contract might default on the arrangement.