Currency swap is a financial instrument used by companies and institutions to secure better loan rates in foreign currencies than they might be able to obtain directly in the foreign market. They involve the exchange of principal and interest payments in one currency for principal and interest payments in another currency between two parties.

During a currency swap, parties agree in advance whether they will exchange the principal amounts of two currencies at the beginning of a transaction. The exchange rate depends on the two principal amounts. At the maturity, the same principal amounts must be exchanged.

Lets see the working of currency swap with an Example

Company X is based in the USA and wants to borrow Euros which it wants to invest in Europe only. And Company Y is based in Europe and wants to borrow U.S. dollars to invest in US markets.

Both companies find that they can get better interest rates by borrowing the money in the currency’s home countries which means that the company in USA wants to borrow euro in Europe and the company in Europe wants to borrow dollars in USA because they are coming cheaper there.

Now If company X and Y have entered in a swap then, Company X borrows an agreed amount in U.S. dollars at the prevailing interest rate in the U.S., say $10 million at 3% annual interest and Company Y borrows the equivalent amount in euros at the prevailing interest rate in Europe, say €10 million at 2% annual interest.

They then swap the principal amounts, meaning Company X receives €10 million, and Company y receives $10 million.

Throughout the term of the swap, Company X will pay the interest on the €10 million at 2% to Company y and Similarly, Company Y will pay the interest on the $10 million at 3% to Company X.

At the end of the swaps agreement, the principal amounts are swapped back at the same exchange rate as the initial transaction.  This means that the Company X returns €10 million to Company Y, and Company Y returns $10 million to Company X.

What are the benefits of this whole transaction?

One, Company X gets access to euros at a cheaper interest rate than if it borrowed directly in the euro market and Company Y gets access to dollars at a cheaper interest rate than if it borrowed directly in the U.S. market.

Two, there is an improved Loan Access to the companies.

Third, this is also a hedge/security against the Currency Risk against exchange rate fluctuations.

Fourth is the flexibility in Financing as Companies can access money during the times of need and at desired interest rate.

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