Potentially get a better rate on your loan in another currency.
In a currency swap, you trade a loan with another party to get a lower interest rate on that loan. You and the other party take advantage of the fact that you can get cheaper loans in your respective countries.
What is a currency swap?
In a currency swap, you trade loan payments in one currency for the equivalent sum in a second currency. These loan payments include the principal — or the amount borrowed — and interest.
A company or a bank is the typical party of a currency swap, not necessarily an individual.
Why is a currency swap useful?
It’s often difficult to get favorable loans in foreign countries. For example, a business owner may be unable to get a foreign loan at a low interest rate.
In your home country, it’s relatively easy to get a loan with a reasonable interest rate. But it might be difficult for a foreign business owner to get equally favorable terms in your country. The same goes for you in other countries.
That situation creates the right elements for a currency swap. With a currency swap, you and a foreign business owner can essentially take out loans for each other and swap those loans to mutually benefit from lower interest rates.
Currency swaps: An example
Say you need to borrow 500,000 euros to do business in France. You approach multiple French banks inquiring about loans, but you run into the same problem each time: The loans come with sky-high interest rates.
At the same time, a French business owner needs to borrow the same amount as you do but in US dollars — let’s say $550,000. Like you, all he gets from American banks are exorbitant interest rates.
There’s an opportunity for a currency swap here:
- First, you take out a $550,000 loan from your bank.
- At the same time, the French business owner takes out a 500,000 euro loan from his bank.
- Now you and the French business owner effectively swap your loans: You give him $550,000, and he gives you 500,000 euros.
- You repay the loan you took out from your bank, and he does the same with his bank.
Currency swap vs. foreign exchange swap
A currency swap is different from a foreign exchange swap. A foreign exchange swap involves simultaneously borrowing currency from and lending currency to another party.
One drawback to keep in mind is there’s a possibility the other party could default on loan payments. It may also be expensive to set up a currency swap, because you might need to use intermediaries to find another party that’s looking for a swap. For more general information on currency transactions, read our guide on other forms of foreign exchange.