A currency swap involves the exchange of loan in one currency for a loan in another currency and both principal and interest payments are exchanged. It does not include the legal swapping of actual debts but an agreement to meet certain cash flows under loan or lease agreements.

Generally two kinds of currency swaps have been used in the markets. These are fixed to fixed swaps and fixed (floating) to floating swaps which sometimes called as circus swaps or currency coupon swaps.

Although the first step may be notional, typical currency swaps involves three steps;

1. Initial exchange of principal amount: In the first step, the counterparties exchange the principal amounts of the swap at an agreed exchange rate. This rate is generally based on the spot exchange rate however, a forward rate set in advance of the swap commencement date may also be used. The principal amounts may be exchanged on physical or notional, without any physical change, basis.
2. Exchange of interest: It is the second key step for a currency swap. The counterparties exchange interest payments on agreed dates based on outstanding principal amounts at the fixed interest rates agreed at the beginning of transaction.
3. Re-exchange of principal maturity: This step involves re-exchange of the principal sum at the maturity date by the counterparts. In order to determine the actual sums involved generally the original spot rate is used.

The counterparties to a “fixed-to-fixed currency swap” may wish to enter the swap because of each one’s comparative advantage which may be in either direction. It can be illustrated by an example quoted from Winstone (1995).

Source: Adopted from Winstone (1995)

The above table shows that a US company is able to borrow from low fixed rates in US bond market. On the other side, a UK company is also able to raise low fixed rates funds from UK bond market. In case of both the companies wish to raise funds denominated by other country’s currency, first, each will borrow from its own domestic market by using the comparative advantage. Second, via fixed-to-fixed swap each will be able to raise lower cost of their funds in terms of foreign currency. However, the case is such that the US company’s credibility is better in each market, the swap transaction would be as it is shown in the above Table.

The table illustrates that the US company has a comparative advantage in both bond markets, but it will also prefer swap. Because by sharing the gain among the parties, the US company, the UK company and the dealer, each of them may raise funds with lower costs. Therefore, each company borrows from the domestic markets and exchanges the principals from the rate of 7.0% for sterling and 6.5% for US dollar.

Source: Winstone (1995)

During the life of swap UK and US companies will service each other’s debt. They will receive interest which completely matches the coupon payments. Besides, dealer makes 1.0% loss on sterling and a gain of 1.5% on US dollars which means a net gain of 0.5%.

Source: Winstone (1995)

On the other hand, during the swap period the dealer is exposed to exchange risk if the US dollar depreciates and sterling appreciates. This exchange risk should be hedged in the forward market.

These swaps are used for to swap from fixed rate obligations in one currency to floating rate obligations in another currency.

Similar to the previous example, a US company is able to borrow at fixed rate in US bond markets, while a UK company is able to borrow sterling at floating LIBOR based rates. In case of foreign currency fund requirements, a cross-currency coupon swap will reduce each company’s lending cost.

The following figure shows the mechanism of cross-currency coupon swaps. Assume that the US dollars at fixed rates are priced in the swap at a number of basis points above the T-bond rates. The dealer might quote 71 - 78 bp if the T-bonds are currently yielding 7.50% p.a. then fixed rate payer (UK company) will pay 7.50% + 78bp = 8.28% against 6m sterling LIBOR received flat. The counterparty will receive 71bp over T-bond yield which is 7.50% + 71bp = 8.21% fixed and pay 6m LIBOR sterling flat. The spread of 7bp will be retained by the dealer as a gain from this transaction.

Source: Winstone (1995)