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What is a foreign currency swap?

What is a foreign currency swap?

These are generally referred to as currency swaps or cross-currency swaps , since “foreign” is a little redundant (currencies are from different countries anyway).

Central banks and large institutions sometimes swap principal amounts and loan interest in their domestic currency in exchange for a foreign currency, to provide liquidity and a hedge. Currency swaps are where banking institutions, particularly central banks, exchange a loan in one currency for a loan in another currency.

These are different from Interest Rate swaps, where just the interest payments are exchanged, which is done to diversify interest rate exposure (especially regarding variable rates). They are also different than what is called an FX swap or Forex swap, where just principal amounts are swapped and there are no interest payments: these work like zero-coupon bonds mixed with forward contracts, since the settlement amount at the end of the lending period are generally more than the amounts borrowed, unless the arrangement is to settle at current spot prices.

In a currency swap the principal amount and the interest payments are exchanged. Currency swaps hedge against exchange rate fluctuations, and they also give the bank some liquidity in the foreign currency, which they can use to do business or make loans with entities in that country. Interest payments are made to the lender in the currency that was borrowed by the payee.

Such contracts are over-the-counter instruments that are negotiated and transacted between two parties, perhaps with an intermediary, off-exchange. Off-exchange means that these are not prepackaged instruments traded on exchanges like stocks and other securities.

What is an FX Swap?
What are Foreign Currency Effects?
What are Foreign Deposits?

Keywords: zero-coupon bond, over-the-counter (OTC), forward contracts, foreign currency markets, currency swaps, forex market, off-exchange,