Question

5. Explain how a currency swap works, and what it achieves.

Answer 1

CURRENCY SWAP

currency swap is an agreement between two parties who exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. This exchange is made in spot rate. Here the currency of one country is swap with the currency of another country at the spot rate. A currency swap can be considered as a interest rate derivative. Interest rate derivstives are those derivatives which will use interest as the benchmark. Here actually two currencies are spanning.

We should know how the currency swap is working and what it achieve.

Here in currency swap there will be principle and interest along with that and this will be get exchanged in two currencies. This is the swap process. Currency swap and interest rate swap are almost same but there is a difference that is in interest rate swap the interest amount only get exchanged but here in currency swap both the principle and interest are taken into consideration. During the term of the agreement the parties needs to pay the interest amount. This is how it works.

Then why this currency swap is used and what the parties achieve from this swap .This is a question we should answer.

There will be many exchange rate risk and borrowing cost happens while exchanging the currencies. The purpose of using currency swap is to reduce these kind of risk and reduce the borrowing cost of currency. By using currency swap we can reduce bith of these things. And another need is that apart from interest rate swap here in currency swap there we can exchange the principle amount too. These are the need of currency swap.

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