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Understanding the Difference Between Currency Swaps and Interest Rate Swaps

Confused with the various swap rates in forex trading? Here’s what you need to know about currency swaps and interest rate swaps.

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

 

A big concern you might have when trading forex is how to protect your trades against exchange rate fluctuations between two currencies. Typically used by institutional investors, financial institutions and multinational firms, currency swaps and interest rate swaps offer just such protection. Although both types of swaps are over-the-counter derivative instruments to trade forex and hedge against exchange rate risks, there are subtle differences. Here’s a deeper dive into the two.

 

1. What is Currency Swap?

Also known as cross-currency swaps, this is a contract between two parties to exchange a pre-decided principal amount in one currency for an equivalent amount in another currency. The dates on which these payments are to be made are fixed by the duration of the contract.

There are two key reasons why currency swaps are used as over-the-counter derivative instruments. Firstly, these contracts are used to minimise the cost of borrowing foreign currency, and, secondly, they are used to mitigate exposure to fluctuations in exchange rates.

In this type of swap, the two parties agree to exchange an equivalent amount in two different currencies and then trade the currencies back later, at a pre-determined date. A currency swap could last for weeks, months and even years. Also, not all swaps include the payment of interest. Those that do can either agree on a fixed or floating interest rate. Here, either both parties pay a fixed or floating rate, or one party pays a fixed rate while the other pays a floating rate.

 

How it Works

For a currency swap, two parties enter into an agreement regarding whether they will exchange an equivalent amount in two specific currencies on a particular date. The principal amounts decided upon establish an implied exchange rate between the two currencies.

For example, if the two parties agree to exchange €10,000 for $11,500, it sets the EUR/USD exchange rate at 1.15. Now, when the contract matures, these two amounts are exchanged by the two parties, regardless of the prevailing exchange rate on that specific date.

Such contracts are often used by multinational corporations wanting to expand to a new country. They would need to invest a large sum of money in the domestic currency of the country they wish to enter. So, rather than borrowing from the market, the company could decide to enter into a currency swap to pay a pre-determined interest rate on the borrowed capital, along with the principal amount.

Did You Know?

The pricing of a currency swap is traditionally expressed in terms of the London Interbank Offered Rate (LIBOR). However, recent criticism regarding the validity of this benchmark has led to regulators in the UK and US deciding on phasing LIBOR out by June 30, 2023. LIBOR will be replaced by the Secured Overnight Financing Rate (SOFR) after this date.

2. What is Interest Rate Swap?

 

This is a forward contract in which two parties agree to exchange the interest rate payments in one currency for that in another on a pre-specified future date, based on a particular principal amount. Here too, while the interest rate could be fixed or floating, the contract is used to minimise risks associated with exchange rate fluctuations or enhance exposure to these fluctuations to earn a profit.

Interest rate swaps are also sometimes known as plain vanilla swaps, since they are the original and usually simplest of the swap instruments. Also, being an over-the-counter instrument, the contract between the two parties can be based on their desired specifications. In other words, it can be customised to the needs of the two parties.

Financial institutions use this type of contract to manage credit risks, hedge against losses or speculate in the forex market. Any decline in the interest rate during the lifetime of the contract, compared to the fixed rate agreed upon, can help the receiver of the fixed rate payment earn a profit. Similarly, an increase in the interest rate beyond that priced into the contract could lead to losses.

Did You Know?

The first ever swap was used by the UK in the 1970s . The British government began taxing forex transactions that included the GBP, as part of its policy involving foreign exchange controls. This made it more difficult for the Pound Sterling to leave Great Britain.

 

3. Currency Vs. Interest Rate Swaps

 

Essentially, the two types of contracts differ in only one specific way. In currency swaps, the two parties agree to exchange the principal amount or cash flow, where one party agrees to receive a specific amount of one currency while paying a pre-determined amount in another currency to the counterparty.

On the other hand, interest rate swaps are contracts where interest payments are exchanged, based on the agreed-upon interest rate differential between two currencies at the onset of the contract.

2. What is Interest Rate Swap?

This is a forward contract in which two parties agree to exchange the interest rate payments in one currency for that in another on a pre-specified future date, based on a particular principal amount. Here too, while the interest rate could be fixed or floating, the contract is used to minimise risks associated with exchange rate fluctuations or enhance exposure to these fluctuations to earn a profit.

Interest rate swaps are also sometimes known as plain vanilla swaps, since they are the original and usually simplest of the swap instruments. Also, being an over-the-counter instrument, the contract between the two parties can be based on their desired specifications. In other words, it can be customised to the needs of the two parties.

Financial institutions use this type of contract to manage credit risks, hedge against losses or speculate in the forex market. Any decline in the interest rate during the lifetime of the contract, compared to the fixed rate agreed upon, can help the receiver of the fixed rate payment earn a profit. Similarly, an increase in the interest rate beyond that priced into the contract could lead to losses.

Did You Know?

The first ever swap was used by the UK in the 1970s . The British government began taxing forex transactions that included the GBP, as part of its policy involving foreign exchange controls. This made it more difficult for the Pound Sterling to leave Great Britain.

 

3. Currency Vs. Interest Rate Swaps

Essentially, the two types of contracts differ in only one specific way. In currency swaps, the two parties agree to exchange the principal amount or cash flow, where one party agrees to receive a specific amount of one currency while paying a pre-determined amount in another currency to the counterparty.

On the other hand, interest rate swaps are contracts where interest payments are exchanged, based on the agreed-upon interest rate differential between two currencies at the onset of the contract.

Key Takeaways

  • Both currency swaps and interest rate swaps are over-the-counter derivatives instruments usually used by institutional investors, financial institutions and multinational corporations.
  • They are used to minimise the risk of exchange rate fluctuations.
  • In a currency swap, two parties agree to exchange a specific amount of one currency for an equivalent amount in another currency, based on an agreed-upon exchange rate at the start of the contract.
  • These contracts can last for weeks, months or even years.
  • Interest rate swaps are an agreement between two parties to exchange the interest rate differential between two currencies on a pre-decided date, determined by the tenure of the contract.
  • Interest rate swaps are sometimes also known as plain vanilla swaps, since they tend to be the simplest type of swap.

 

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Investing in CFDs involves a high degree of risk that you will lose your money due to the use of leverage, particularly in fast moving markets, where a relatively small movement in the price can lead to a proportionately larger movement in the value of your investment. This can result in loses that exceed the funds in your account. You should consider whether you understand how CFDs work and you should seek independent advice if necessary.

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