CFM11232 - Understanding derivative contracts: managing risk

Currency swaps

Another way of hedging exchange risks is by the use of currency swaps. You are most likely to see currency swaps either between banks, or between a member of a large group of companies and a bank, usually hedging substantial borrowings or lendings.

The basic idea of a swap is explained at CFM11090, and there is an example of an interest rate swap at CFM11090. A currency swap is similar to an interest rate swap, in that the parties exchange interest obligations for an agreed period. But it has extra complications because two different currencies are involved. One of those currencies may be sterling: equally, a UK company may enter into a swap involving two different non-sterling currencies, for example the US dollar and the Japanese yen.

All currency swaps have two basic components:

• an exchange of interest receipts and obligations over the duration of the swap
• an exchange of currencies at the end.

There may also be an initial exchange of currencies, but this is optional.

You can best see how a currency swap works by looking at an example – see CFM11232a.