currency swap money transfers

How do currency swaps work?

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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.

How foreign exchange swaps work

Bottom line

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.

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