Currency Swap

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A currency swap is a spot transaction on the over-the-counter market that is executed at the same time as a forward transaction, with currencies being exchanged at both the spot date and the forward date. One currency is bought at the spot rate and date, while the transaction is reversed at the forward date and rate. Thus, once the swap expires, both parties return to their original positions. The currency swap acts as an investment in one currency and a loan in another. The amount of a foreign exchange swap usually begins at $5 million, so this is not an option for smaller foreign exchange cash positions.

The exchange rates of both transactions are set at the time of the initial transaction, so the difference between the two rates is caused by the interest differential between the two currencies over the duration of the swap.

The currency swap is useful when a company forecasts a short-term liquidity shortfall in a specific currency, and has sufficient funds in a different currency to effect a swap into the currency where funds are needed. In addition, the company offsets what is likely to be a high interest rate on the short-term debt with the lower interest rate that it was earning on funds in a different currency.

The currency swap is also useful when a foreign currency cash flow is delayed, and a company would normally be obligated to sell the currency on the expected receipt date, as per the terms of a forward exchange contract. To meet this contractually-obligated payment, a company can swap its other currency reserves into the currency that must be sold, and reverse the transaction later, when the expected cash flow eventually arrives.