A foreign currency (FX) swap is a deal between two international parties where they exchange interest payments on loans in different currencies.
Sometimes, the swap can also include the exchange of the principal amount, which is returned at the end of the agreement. However, most of the time, the swap only involves a notional principal, which is used solely for calculating interest and isn’t physically exchanged.
Learn more about Foreign Currency Swap
One reason to participate in a currency swap is to secure loans in foreign currencies at better interest rates than what you might find if you were to borrow directly from a foreign market.
Back in the 2008 financial crisis, the Federal Reserve offered several developing nations facing liquidity issues the chance to engage in currency swaps for borrowing.
In 1981, the World Bank executed its first-ever currency swap with IBM, facilitated by the investment banking firm Salomon Brothers. In this deal, IBM exchanged German Deutsche marks and Swiss francs with the World Bank for U.S. dollars.
Foreign currency swaps can be set up for loans that last up to 10 years. Unlike interest rate swaps, currency swaps can also include exchanges of principal amounts.
The Process
In a foreign currency swap, both parties involved pay interest on each other’s loan principal amounts for the duration of the agreement. Once the swap concludes, if the principal amounts were exchanged, they are swapped back at the previously agreed rate (which helps to mitigate transaction risk) or at the current spot rate.
Currency swaps have traditionally been linked to the London Interbank Offered Rate (LIBOR), which is the average interest rate that international banks charge each other for loans. This rate has served as a standard for other global borrowers.
However, starting in 2023, the Secured Overnight Financing Rate (SOFR) will take over as the primary benchmark, replacing LIBOR. In fact, by the end of 2021, no new transactions in U.S. dollars were using LIBOR, although it will still provide rates for existing agreements.
Conclusion
Foreign currency swaps are deals between two parties where they trade principal and interest payments in different currencies. This helps them handle risks related to currency and interest rates. Companies and governments often use these swaps to get more favorable financing options or to protect themselves from long-term changes in currency values.