Currency swap

A currency swap (or a cross currency swap) is a foreign exchange derivative between two institutions to exchange the principal and/or interest payments of a loan in one currency for equivalent amounts, in net present value terms, in another currency. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from interest rate swap, for in currency swap, both principal and interest of loan is exchanged from one party to another party for mutual benefits.

Currency swaps are over-the-counter (OTC) derivatives.

There are multiple different ways in which currency swaps can exchange loans:

Currency swaps have many uses, some are itemized:

Additionally, cross-currency swaps are an integral component in modern financial markets as they are the bridge needed for assessment of yields on a standardised USD basis. For this reason there are also used as the construction tool in creating collateralized discount curves for valuing a future cashflow in a given currency but collateralized with another currency. Given the importance of collateral to the financial system at large, cross-currency swaps are important as a hedging instrument to insure against material collateral mismatches and devaluation,.

For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging either of the following:

Suppose the British Petroleum Company plans to issue five-year bonds worth £100 million at 7.5% interest, but actually needs an equivalent amount in dollars, $150 million (current $/£ rate is $1.50/£), to finance its new refining facility in the U.S. Also, suppose that the Piper Shoe Company, a U. S. company, plans to issue $150 million in bonds at 10%, with a maturity of five years, but it really needs £100 million to set up its distribution center in London. To meet each other's needs, suppose that both companies go to a swap bank that sets up the following agreements:

The British Petroleum Company will issue 5-year £100 million bonds paying 7.5% interest. It will then deliver the £100 million to the swap bank who will pass it on to the U.S. Piper Company to finance the construction of its British distribution center. The Piper Company will issue 5-year $150 million bonds paying 10% interest. The Piper Company will then pass the $150 million to swap bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its U.S. refinery.

...
Wikipedia