What Is a Foreign Currency Swap?

A foreign currency swap is a type of contract that calls for the exchange of specific types of currency between two foreign parties. Those parties may be individual investors, corporate investors, or even the governments of two different nations. The process calls for creating an agreement that calls for exchanging or swapping the payments on one loan structured with one of the currencies for a loan of similar value and terms that is structured with a different currency.

There are a few distinctive things that set the foreign currency swap apart from other types of interest swap deals. One has to do with the fact that multiple currencies are used as part of the deal’s structure. This can allow both parties to benefit from the arrangement, depending on what happens with the rate of exchange that applies to those currencies over the duration of the loans involved. In addition, this strategy normally calls for utilizing loans of similar duration, usually no more than ten years. A foreign currency swap also involves exchanging payments on both the principal and the interest, rather than just the interest alone.

One of the chief benefits of a foreign currency swap is that it can help a foreign company to have access to interest rates that would be impossible otherwise. For example, if a UK company wanted to establish an operation in the United States, this method would make it possible to do so and take advantage of the rates that the US partner in the swap could command, rather than relying on the higher rates that would apply to an international loan situation. Assuming that the US partner was also interested in establishing or expanding an operation in the UK, this would in turn allow that partner to also benefit from the swap.

While the foreign currency swap can work to the advantage of both parties, there is always the chance that shifts in the rate of exchange between the currencies involved could undermine those benefits. For this reason, carefully selecting the loan conditions involved with each of the two loans will help to minimize issues that may be created by significant shifts in those exchange rates. Depending on the structure of the deal, it may be possible to allow for fixed and variable rates of interest as well as include some provision within the foreign currency swap that helps to keep the returns to both parties more or less within a reasonable range.