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January 5, 2023

Currency Swaps

How To Get a Better Interest Rate on Your Foreign Borrowing

Your company has migrated to remote work, and you’ve decided to move to your dream city of Paris for a year. Paris housing isn’t cheap, so you find a friend-of-a-friend doing the exact opposite as you—relocating from Paris to New York. Instead of dealing with high rents and the hassle of moving, the two of you swap apartments. You will move to Paris and pay their rent while they move into your New York loft and pay your mortgage. That, in essence, is the idea of a swap.

Currency Swaps and Cross Currency Swaps Explained

What Is a Currency Swap?

A currency swap, sometimes referred to as a cross-currency swap or forex swap, involves the exchange of interest and principal in one currency for the interest and principal in another currency. Interest payments are exchanged at fixed dates throughout the life of the contract.  

Currency Swap Example: What is a currency swap?

Advantage Swaps

In the above example, Company A is in the U.S., and Company B is in Brazil. Each party needs the other’s currency for an investment in the other’s country. They exchange principal amounts and pay the interest on each other’s loans for the duration of the swap. The swap means they don't need to borrow money from a foreign bank with potentially high interest rates due to their unknown credit history. Instead, they use their domestic banking relationship to get a loan at lower interest rates. At the end of the swap period, they return each other’s principal and repay the loans to their respective banks.
 
Some swaps involve only a swap of interest rates with no principal transfer. These are usually fixed vs. float swaps. One party wants a predictable fixed payment, while the other thinks they will benefit financially by taking on a floating-rate loan.

Common Types of Interest Rate Swaps

  • Fixed vs. Float: One leg of the currency swap represents a stream of fixed interest rate payments, while another leg is a stream of floating interest rate payments.
  • Float vs. Float (Basis Swap): The float vs. float swap is commonly referred to as a basis swap. In a basis swap, each swap’s leg represents floating interest rate payments.
  • Fixed vs. Fixed: Both streams of currency swap contracts involve fixed interest rate payments.

Swap It Out

Currency swaps (fx swaps) are a great consideration if you’re thinking of investing in another country. Swaps can minimize your capital outlay and secure loans with lower interest rates.

Takeaways

  1. A foreign exchange swap involves the exchange of interest and principal in one currency for the interest and principal in another currency.
  2. Some swaps involve only a swap of interest rates with no principal transfer. 
  3. There are three common interest swaps: fixed vs. float, float vs. float, and fixed vs. fixed.
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Pangea

AI Hedging for the Future. Empowering organizations to intelligently manage their Foreign Currency Exchange Risk with AI and Automation at scale in the cloud.

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