A currency swap involves the swapping of currency holdings with another party that already has the required currency. This is a risk management technique that offsets the risk of exchange rate fluctuations; it is also an effective way to avoid exchange controls.
The two entities engage in a swap transaction by agreeing upon an initial swap date, the date when the cash positions will be reversed back to their original positions, and an interest rate that reflects the comparative differences in interest rates between the two countries in which the entities are located.
Another use for a currency swap is when a forward exchange contract has been delayed. In this situation, the treasury staff would normally sell to a counterparty the currency that it has just obtained through the receipt of an account receivable. If, however, the receivable has not yet been paid, the company can enter into a swap agreement to obtain the required currency and meet its immediate obligation under the forward exchange contract. Later, when the receivable is eventually paid, the company can reverse the swap, returning funds to the counterparty.
A swap arrangement may be for just a one-day period, or extend out for several years into the future. Swap transactions generally do not occur in amounts of less than $5 million, so this technique is not available to smaller businesses.
A potentially serious problem with swaps is the prospect of a default by the counterparty. If there is a default, the company once again assumes its foreign currency liability, and must now scramble to find an alternative hedge.