Currency Swap

A currency swap is best read as a sequence of three events. At initiation the counterparties exchange principal amounts in two currencies, with the sizes set so the two sums are economically equal at the prevailing spot rate. Over the life of the deal each party services the currency it received, paying interest on the amount borrowed and receiving interest on the amount lent. At maturity the original principal amounts are returned at the rate agreed at the outset, not at the spot rate then prevailing.

The interest legs can be structured in any combination: fixed against fixed, fixed against floating, or floating against floating, with each floating leg referencing a money market rate native to its own currency. Payment dates need not coincide, and payments are generally not netted because they are denominated in different currencies. This is the structural feature that separates a currency swap from a single-currency interest rate swap.

Because the two notionals are fixed at the initiation spot rate, and the interest rates on each leg are set at par swap rates for their respective currencies, the contract has zero value to both parties on day one. Each leg is, in cash flow terms, a bond: a stream of coupons plus a principal repayment.

Valuation after initiation follows directly from that decomposition. Discount the remaining cash flows on each leg using the discount factors of its own currency to obtain two bond values, convert the foreign-currency value into the reporting currency at the current spot rate, and take the difference. A party that receives the currency which has appreciated, or whose interest rates have fallen relative to the terms locked in, shows a gain. Value therefore responds to two drivers at once: the spot exchange rate and the shape of both yield curves.

In practice currency swaps are the plumbing of international debt markets. A corporate treasurer issues where investor demand is deepest and pricing is tightest, then swaps the proceeds into the currency of the assets or operating cash flows being funded. European issuers selling dollar bonds and American issuers selling euro bonds both rely on the swap market to convert the liability back home.

The cost of that conversion is not always symmetric. Persistent imbalances in demand for dollar funding produce a cross-currency basis spread, an adjustment applied to one floating leg so that the swap prices at market rather than at pure interest rate parity. Banks funding dollar assets with domestic-currency deposits, sovereign wealth managers hedging foreign holdings, and multinationals hedging foreign subsidiary debt are all natural users, and the basis is a standard indicator of funding stress.

At Level I the expectations are concrete. Given a scenario, lay out who pays what in which currency at initiation, on each settlement date and at maturity, and state the notional in the second currency implied by a given spot rate. Explain why the position is worth nothing at inception and identify the two market variables that move its value afterwards.

Equally important is the risk comparison. Because principal amounts are genuinely at risk on the final exchange, and because the payments cannot be netted, a currency swap carries materially greater counterparty credit exposure than an interest rate swap of similar size and tenor, with exposure concentrated toward maturity. Candidates should also distinguish the instrument from a short-dated FX swap and from a series of currency forwards, and recognise the economic equivalence between a swapped foreign-currency bond and a domestic-currency liability.