A currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency.
To understand the concept properly, an example is essential.
Imagine that I am an Indian businessman and I need US $1million for five years. My plan was to borrow from a US bank. But there is a usual problem- that if the rupee’s value falls steeply, my debt burden from this loan will go up in rupee terms. One million Dollars today is equal to Rs 7 crores (at $1 =Rs 70). If rupee value falls to Rs 100/1$, I have to pay Rs 10 crore at maturity.
Soon I came to know that there is a US businessman called Robert who need Rs 7 crore. This give me an opportunity. If he and me agrees, I will give him my Rs 7 crore and he will give me $1 million. Both amounts are equal.
Here, I should give him an interest rate prevailing at the US markets in dollars (say 6%). Similarly, Mr Robert has to give me the Indian interest rate (say 8%) in rupees. This we will do for five years.
At the end of the fifth year, Robert will give me back Rs 7 crores and I will give him back the $1 million. Here, we simply re-exchanged the original principal amounts.
This arrangement is called currency swap. There occurred an exchange or swap of principals in terms of two currencies.
A currency swap between two parties is the exchange of a notional principal with one another in order to gain exposure to a desired currency.
As we mentioned earlier, a simple currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency.
The two specified principal amounts are set so as to be approximately equal to one another ($1mn = 7 crore rupees in this example), given the exchange rate at the time the swap is agreed.
Regarding interest rates, it will be paid at regular intervals specified in the swap agreement. The two parties will exchange interest payments on their respective principal amounts.
At the end of the swap (end of the fifth year, in our example), the parties re-exchange the original principal amounts. These principal payments are unaffected by the exchange rates prevailing at the settlement time.
Currency swap is usually done by business firms and sometimes by governments. Mostly they are tailor made arrangements or done to suit for each entities.
The main advantage of currency swap is that it reduces foreign exchange risks. Similarly, it reduces interest rate risk also.
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