how a currency swap works
in a currency swap the parties agree in advance whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction the two principal amounts create an implied exchange rate for example if a swap involves exchanging 10 million versus 12 5 million that creates an implied eur usd exchange rate of 1 25 at maturity the same two principal amounts must be exchanged which creates exchange rate risk as the market may have moved far from 1 25 in the intervening years pricing is usually expressed as london interbank offered rate libor plus or minus a certain number of points based on interest rate curves at inception and the credit risk of the two parties due to recent scandals and questions around its validity as a benchmark rate libor is being phased out according to the federal reserve and regulators in the uk libor will be phased out by june 30 2023 and will be replaced by the secured overnight financing rate sofr as part of this phase out libor one week and two month usd libor rates will no longer be published after december 31 2021 1 a currency swap can be done in several ways many swaps use simply notional principal amounts which means that the principal amounts are used to calculate the interest due and payable each period but is not exchanged if there is a full exchange of principal when the deal is initiated the exchange is reversed at the maturity date currency swap maturities are negotiable for at least 10 years making them a very flexible method of foreign exchange interest rates can be fixed or floating india and japan signed a bilateral currency swap agreement worth 75 billion in october 2018 to bring stability to forex and capital markets in india exchange of interest rates in currency swapsthere are three variations on the exchange of interest rates fixed rate to fixed rate floating rate to floating rate or fixed rate to floating rate this means that in a swap between euros and dollars a party that has an initial obligation to pay a fixed interest rate on a euro loan can exchange that for a fixed interest rate in dollars or for a floating rate in dollars alternatively a party whose euro loan is at a floating interest rate can exchange that for either a floating or a fixed rate in dollars a swap of two floating rates is sometimes called a basis swap interest rate payments are usually calculated quarterly and exchanged semi annually although swaps can be structured as needed interest payments are generally not netted because they are in different currencies 