Currency swap
An OTC derivative in which two parties exchange streams of interest payments and/or principal in different currencies on set dates over the swap's life, at an exchange rate agreed at the start.
In plain language
A currency swap lets a borrower turn a loan in one currency into, economically, a loan in another.
The workbook's definition: 'Currency swap' (also known as cross currency swap) means an OTC derivative which commits two counterparties to exchange streams of interest payments and/or principal amounts in different currencies on specified dates over the duration of the swap at a pre-agreed exchange rate.
The exchange rate is based on the prevailing spot rate (or a predetermined forward rate for forward-start swaps) and is locked in for the whole tenure.
It is easy to confuse with its short-dated cousin, the foreign exchange swap. The workbook says the two are "basically the same but there are slight differences":
| Foreign exchange swap | Currency swap | |
|---|---|---|
| What is exchanged | Principal only — once now (short leg), reversed later (long leg) | Interest streams and/or principal, on several dates |
| Rates | Agreed at inception for both legs | Pre-agreed exchange rate for the entire tenure |
| Typical use | Short-term funding and rolling positions | Long-term foreign currency borrowings |
Both are OTC products; exchanges in India do not list them.
How it works
The workbook's structure (Chapter 2, section 2.3.4). An Indian company has a long-term USD borrowing. It is exposed to two risks: USD/INR exchange rate risk and USD interest rate risk. It enters a USD/INR currency swap with a bank at the spot rate of Rs 74:
| Flow | Company receives from bank | Company pays to bank |
|---|---|---|
| Interest | USD floating interest payments | INR fixed interest payments |
| Principal | USD principal amortisations | Equivalent INR principal amortisations at the locked rate |
The USD it receives services the USD loan. What is left is a rupee obligation at a fixed rate and a fixed exchange rate — both risks removed. The workbook notes the exchange of initial principal at the start is not obligatory.
Scale. The BIS April 2022 survey the workbook reproduces shows daily OTC turnover of USD 3,810 billion in foreign exchange swaps against USD 124 billion in currency swaps — FX swaps are the largest FX instrument of all, currency swaps among the smallest.
Among generic derivatives, the workbook describes a swap as a series of forward contracts and places FX swaps and currency swaps in the currency row of its forward / futures / swap / option table, as "mainly OTC".
A worked example
Illustrative. The loan size, repayment schedule and interest rates are hypothetical; the Rs 74 swap rate is the workbook's.
Kaveri Engineering has borrowed USD 10 million for 5 years at a USD floating rate. It swaps the loan into rupees with its bank at Rs 74.
Rupee principal equivalent = 10,000,000 × 74 = Rs 74 crore
Suppose the swap fixes the rupee interest at 8% a year and the loan amortises USD 2 million a year.
Year 1 flows:
| USD leg (received from bank, passed to lender) | INR leg (paid to bank) | |
|---|---|---|
| Principal | USD 2,000,000 | 2,000,000 × 74 = Rs 14.8 crore |
| Interest | USD floating on USD 10 million | 8% × Rs 74 crore = Rs 5.92 crore |
Now suppose USDINR has risen to 83 by the first repayment.
Unhedged cost of USD 2 million = 2,000,000 × 83 = Rs 16.6 crore
Swapped cost = Rs 14.8 crore
Saved on principal alone = Rs 1.8 crore
If USDINR had fallen instead, the company would still pay at 74 — the swap removes the downside and the upside. And if USD floating rates rose, the bank bears that, not Kaveri.
Why NISM asks about it
Chapter 2, section 2.3.4 (Swaps), defines interest rate swaps, foreign exchange swaps and currency swaps and gives the USD-borrowing example. Chapter 1, section 1.2.2, carries the BIS turnover table in which FX swaps dominate. A sample question at the end of Chapter 2 asks which derivatives trade only on exchanges — currency swaps and FX swaps are the OTC distractors.
Common exam traps
- Currency swap = interest and/or principal streams over the tenure; FX swap = principal only, two legs. The workbook calls them basically the same with slight differences — know the differences.
- "Cross currency swap" is another name for a currency swap, not for an FX swap.
- Initial exchange of principal is not obligatory in a currency swap.
- The exchange rate is locked for the entire tenure, based on spot (or forward for forward-start swaps).
- Swaps are mainly OTC. They are not among exchange-traded currency derivatives in India.
- A currency swap on a USD loan hedges both exchange rate risk and USD interest rate risk.
Where this is taught
- Series I · Chapter 2: Foreign Exchange Derivativesintroduced here
- Series X-B · Chapter 11: Taxation of Equity Productsintroduced here
Related terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Counterparty credit riskThe risk that the other party to an OTC derivative fails before the settlement date. It does not arise in exchange-traded derivatives, where the clearing corporation becomes central counterparty.
- Foreign exchange forwardAn OTC derivative involving the exchange of two currencies on a specified future date more than two business days away, at a rate agreed on the date of the contract.
- Foreign exchange swapAn OTC derivative in which two currencies are actually exchanged on one date (the short leg) and re-exchanged at a later date (the long leg), at rates agreed at the time of the contract.
- Interest rate swapAn agreement to exchange streams of interest payments on a notional principal for a set period — typically fixed against floating — where only the net difference ever changes hands.
- Exchange Rate RiskThe risk that an investment’s value, measured in the home currency, changes because foreign exchange rates move. A falling rupee raises returns on foreign assets; a rising rupee cuts them.
- OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
- Cross currency swapAn OTC agreement to exchange floating-rate payments in one currency for floating-rate payments in another, with principal typically exchanged at both the start and end, used to hedge foreign-currency portfolio exposure.
- Credit Default SwapA contract in which a protection buyer pays a regular premium to a protection seller, who agrees to pay any loss in value on a specified reference obligation if a credit event such as default occurs.
- SwapA derivative in which two parties agree to a specified exchange on future dates — typically one pays a fixed interest rate and receives a floating one on an agreed principal that never itself changes hands.