A currency swap, or a cross-currency swap, is a contract between two parties to exchange interest payments and principal amounts in two different currencies at a pre-agreed rate of exchange. So, how does currency swap work? At the outset of the contract, the two parties exchange specific amounts of two currencies, and they then repay them according to a pre-agreed structure. Although considered derivatives, currency swaps are not used for speculation; rather they are utilised to lock in a fixed exchange rate or hedge against fluctuations. The payable interest rates are highly customisable. That is, they can be fixed, variable, or even both.
In other words , a foreign exchange swap/ currency swaps refers to a spot sale of a currency combined with a forward repurchase of the same currency—as part of a single transaction. For example, suppose that Citibank receives a $1 million payment today that it will need in three months, but in the meantime it wants to invest this sum in euros. Citibank would incur lower brokerage fees by swapping the $1 million into euros with Frankfurt’s Deutsche Bank as part of a single transaction or deal, instead of selling dollars for euros in the spot market today and at the same time repurchasing dollars for euros in the forward market for delivery in three months—in two separate transactions. The swap rate (usually expressed on a yearly basis) is the difference between the spot and forward rates in the currency swap.
Most inter bank trading involving the purchase or sale of currencies for future delivery is done not by forward exchange contracts alone but combined with spot transactions in the form of foreign exchange swaps. In April 2010, there were $1,765 billion worth of foreign exchange swaps outstanding. These represented 44 percent of total inter bank currency trading. Spot transactions were $1,490 billion or 37 percent of the total. Thus, the foreign exchange market is dominated by the foreign exchange swap and spot markets.