Deep Dive · Swaps · Lesson 4
Currency
Swaps
Big Idea
A currency swap exchanges principal and interest in two different currencies. Unlike an interest rate swap, where the notional is only a reference figure, the principal here usually is exchanged — at the start and again at maturity. It is the tool companies reach for to fund in, or hedge their exposure to, a foreign currency.
- Two currencies, two interest streams — each side pays interest on the currency it received.
- The principal really moves — swapped at the start and swapped back at the end.
An interest rate swap reshapes your rate; a currency swap moves you into another currency.
Two Currencies, Two Streams
In a currency swap, each side wants the currency the other already has. So they hand over principal in one currency and receive principal in another, then over the life of the deal each pays interest on the currency it received, and at the end they return the original principals. It runs in three clear stages.
- At the start — the two sides swap principal, each handing over the currency the other needs.
- During the life — each side pays interest on the currency it received, on the agreed schedule.
- At the end — they swap the original principals back, returning what they started with.
Principal out, interest across, principal back — three exchanges, not one.
A Worked Example
A US company needs euros for a European project; a European company needs dollars. The spot rate is $1.10 per euro, so they agree a currency swap on €10,000,000 & $11,000,000 — the same value on each side. Here is how the three stages play out.
| Stage | US Company | European Company |
|---|---|---|
| At the start | Hands over $11,000,000, receives €10,000,000 | Hands over €10,000,000, receives $11,000,000 |
| During the life | Pays interest in euros on €10,000,000 | Pays interest in dollars on $11,000,000 |
| At maturity | Returns €10,000,000, gets $11,000,000 back | Returns $11,000,000, gets €10,000,000 back |
Each side pays interest on what it received, and at $1.10 per euro €10,000,000 = $11,000,000 throughout.
How It Differs From an Interest Rate Swap
Both are swaps — streams of scheduled exchanges — but a currency swap does something an interest rate swap never does: it actually moves principal, in two currencies.
| Feature | Interest Rate Swap | Currency Swap |
|---|---|---|
| Currencies involved | One | Two |
| Principal exchanged? | No — notional is only a reference | Yes — at the start and at maturity |
| Main purpose | Reshape interest-rate exposure | Fund or hedge across currencies |
Why Use One
Companies reach for a currency swap when they need to operate across borders and a plain loan would leave them exposed. The common reasons:
- Cheaper funding in a foreign currency than borrowing it directly.
- Hedging a foreign investment or foreign-currency debt against exchange-rate moves.
- Access to a currency or market where you cannot easily borrow on your own.
Interactive Checks
Check 1 of 3
Someone asks you what actually gets exchanged in a currency swap.
What does a currency swap exchange?
Check 2 of 3
You are comparing a currency swap with an interest rate swap.
How does a currency swap differ?
Check 3 of 3
A US company needs euros to fund a European project.
A currency swap lets it:
Common Beginner Mistakes
- ❌ Assuming the principal is not exchanged. Unlike an interest rate swap, a currency swap really does move principal — at the start and again at maturity.
- ❌ Confusing it with a single FX forward. A swap is a stream of exchanges, and it swaps principal both ways — not one trade on one date.
- ❌ Thinking it is only about interest. The interest streams matter, but the principal exchange is central to what a currency swap does.
- ❌ Ignoring counterparty risk. These deals run for years, so the risk that the other side stops paying builds over the swap's long life.
Quick Memory Tool
- Currency swap = principal + interest in two currencies
- The principal is exchanged — at the start and at maturity
- Each side pays interest on the currency it received
- Used to fund or hedge across borders
- Differs from an interest rate swap, which exchanges no principal and uses one currency
Next Lesson
Credit Default Swaps — the odd one out. Next we meet the swap that works like insurance on a borrower, where the buyer pays a premium and the seller pays out on a default.