Among the currency exchange methods, there is a type of trade called the currency swap and its particular operation can be of interest to the professional investors of the foreign exchange market. We will therefore explain to you here in detail what this swap consists of and what are its real uses and advantages.

What is a currency swap?

A currency swap is when two entities exchange a given amount of currencies with the agreement to return these currencies to each other at the end of a pre-determined period.

Often used by finance professionals or in international commerce, a currency swap can have a variable duration with a maximum of 30 years. Legally, the swap is not a loan and therefore, is not obligatorily mentioned in the accounts of the companies concerned.

A currency swap is therefore about exchanging a certain amount of foreign currencies without taking into account the interest as the two currencies used here are different.

The objective of these currency exchanges for the companies is to have foreign currencies at their disposal to make purchases or pay providers without being liable to supplementary taxes. For example, an American company buying commodities in Europe will be able to exchange currency with a French company subcontracting a part of its production to the United States. In this way, each of the two parties will benefit.

Currency Swaps and interest rates

Most of the time, currency swaps are coupled to swaps in the interest rate. This is the case when the companies concerned wish to make purchases of fixed rate bonds or swap them against variable rate bonds hoping to make a profit at the contract term. This is also particularly the case when an organisation seeks to acquire cheap bonds in order to exchange them against bonds in the currency that interests them.

For example, let us take our American company and French company. Here, these two companies could agree on a currency swap by indicating the quantity but also the interest rate which applies as well as a pre-determined exchange date. The advantage here is that this exchange date can be modified according to negotiations during a 10 year period, which makes it possible to target a more interesting true interest rate.

We distinguish between three types of currency swap according to the interest rates. The first is the Basic Swap indicating that the interest rate of the two currencies is variable. It is the simplest system.

Another type of currency swap offers a fixed rate against a variable rate. In this precise case, the interest is paid at a fixed rate as with the classic interest rate swaps and we use an absolute interest rate or spread at a certain predefined rate. However there are no spreads on those of a variable interest rate.

Finally, we have currency swaps where the two interest rates are variable. In this case, we calculate the difference between these two rates and charge the result to one or the other party according to the movement direction.

Why were currency swaps created?

Financial exchanges, as detailed by the currency swaps, have always existed. The objective of these exchanges was above all to avoid controls. But, during the financial crisis of 2008, the Fed finally decided to encourage the central banks to themselves use this type of currency exchange in order to promote exchanges with Brazil, South Korea or Mexico.