How They Work

• Currency swaps work by having two institutions borrow money in their currency, then swap it--and the interest payments on it--with one another for a set period of time. This can grant them access to markets, interest rates and exchange rates that they would not otherwise have been able to access.
  
  

Risks

• Currency swaps have two risks, where interest rate swaps only have one. In an interest rate swap, the only risk is that the interest rate being paid will rise to an unprecedented level. In a currency rate swap, though, the value of one of the currencies can fall or rise, thus making the interest payments less valuable.
  
  

Example

• Assume an American bank wants to lend $1,000 (borrowed at 3 percent) to British investors, but needs pounds sterling to do so. The exchange rate is 1:1, so the bank agrees to a currency swap with a British bank that has the converse, but borrowed at 5 percent.
  
  Since the British bank owes a higher interest rate, it will make payments to the American bank of 2 percent of the principal every year--in dollars. However, if the currency rate dramatically changes to 1:2, then the American bank is actually paying more. A payment that was $30 ($1,000 x .03) is now $60, as the amount of dollars required to buy pounds has risen. The British bank, on the other hand, is only paying 25 pounds to make its payments of $50, where it was previously paying 50 pounds.