Advanced Financial Management · The use of financial derivatives to hedge against forex risk

Currency Swaps Explained for ACCA AFM

Updated 11 October 2026 · Fact-checked

A currency swap is an agreement between two parties to exchange principal and interest payments in different currencies for a set period. It hedges long-term exchange rate exposure and lets firms borrow where they have an advantage. To solve a question, set out the exchange of principal, the interest flows and the final re-exchange at the agreed rate.

Understand Currency Swaps

A currency swap is a contract between two parties. One party pays interest in one currency and the other pays interest in a second currency. At the start, the parties usually exchange principal amounts. At the end, they swap the principal back at the same exchange rate. The rate is fixed at the start, so the exchange rate risk on the loan is removed.

Why use it? Forward contracts and money market hedges work well for short periods. Forwards are rarely available beyond a year or two. If a company has a ten-year foreign currency loan, or a long-term foreign income stream, a swap can match it. It is a long-term hedge.

The second use is comparative advantage. A firm may borrow cheaply in its home market because lenders know it well. A foreign firm may be in the same position in its own market. Each borrows in its home currency at a good rate, then they swap. Each ends up paying interest in the currency it needs, at a cost lower than borrowing directly. The saving is shared between the parties, often with a bank as intermediary taking a fee.

The swap is a separate contract from the underlying loan. The company still owes the original lender. The swap counterparty pays the company the interest the lender needs. The company pays the counterparty interest in the currency it wants. If the counterparty defaults, the company still owes the lender. This is counterparty risk.

A currency swap is different from an interest rate swap. An interest rate swap exchanges interest payments in the same currency, usually fixed for floating, and normally no principal is exchanged. A currency swap involves two currencies and normally exchanges principal. A swap can also combine both, such as fixed in one currency for floating in another.

Key rules to remember

Swap interest payment: Interest = principal × interest rate × time; Calculate each currency leg separately, using the principal in that currency.
Principal in the other currency: Principal B = Principal A × agreed spot rate (or ÷, depending on quotation); Check how the rate is quoted. The same rate is used at the start and at the end.
Saving from comparative advantage: Total saving = (difference in rate for A) − (difference in rate for B); Compare the rate gap between the two firms in each currency. The difference in gaps is the total gain to share.
Net cost after swap: Net cost = rate paid on own loan + swap rate paid − swap rate received; Do this for each party, in the currency it wants to end up paying.

How to solve Currency Swaps questions

Use this method for most currency swap questions. Work one leg at a time and keep the currencies separate.

1Identify what each party wants: which currency it borrows or earns in, and which currency it wants to pay interest in.
2Convert the principal at the spot rate given. This fixes the amount to be swapped in each currency.
3List the rates each party can borrow at in each currency, fixed or floating. Note the loan each will actually take out.
4For comparative advantage, find the rate gap in each currency. The difference between the gaps is the total saving. Remember the bank fee if one is given.
5Agree how the saving is shared (equally unless told otherwise) and set the swap rates so each party gets its share.
6Calculate the annual interest cash flows in each currency for both parties, and the re-exchange of principal at the end.
7Show the net effect on each party. Compare with the cost without the swap, and comment on risks such as counterparty default.

Quickest way: Quick gain-sharing check

When to use it: Use this when the question asks for the benefit of a swap from comparative advantage and time is short.

Write the two firms' rates in the two currencies in a small grid.
Find each firm's gap between the currencies.
Subtract the smaller gap from the larger gap. This is the total saving.
Deduct any bank fee, then split the rest as the question says, usually equally.
Each firm borrows where it has the advantage, then check that its final cost equals its direct rate minus its share.

Common mistakes in Currency Swaps

Applying the wrong exchange rate to interest payments.
Students convert interest at the future spot rate instead of the fixed swap rate.
Fix: Swap flows use the rate agreed at the start. Only the unhedged position uses future spot rates.
Dividing instead of multiplying when converting principal.
Quotation direction is mixed up.
Fix: Write the rate with units, such as $1.50 per £1. Check the answer is sensible in size.
Treating a currency swap like an interest rate swap.
Both are called swaps and both exchange interest.
Fix: State that a currency swap involves two currencies and usually exchanges principal, while an interest rate swap uses one currency.
Forgetting the bank fee when calculating the gain.
The fee is mentioned in the last line of the question.
Fix: Deduct the fee from the total saving before sharing it, and say who bears it.
Ignoring risk in the written part.
Students focus on the numbers only.
Fix: Mention counterparty risk, the fact that the original loan stays in place, and that a fixed rate means losing any favourable currency move.
Swapping the wrong way round, so each firm pays in the currency it does not want.
The needs of each party are not written down first.
Fix: Begin with a one-line statement of what each party wants to pay and receive.

Worked examples

Example 1

Firm X (UK) wants to borrow $15 million for five years at a fixed rate. Firm Y (US) wants to borrow £10 million for five years at a fixed rate. Spot is $1.50 per £1. Fixed borrowing rates: Firm X pays 6% in £ and 8% in $. Firm Y pays 7% in £ and 7.5% in $. Find the total annual saving from a swap through each borrowing in its cheaper relative market, ignoring fees.

Show the solution

Check principals: £10 million × $1.50 = $15 million, so the amounts match.
Gap for X: $ rate minus £ rate = 8% − 6% = 2%.
Gap for Y: $ rate minus £ rate = 7.5% − 7% = 0.5%.
Difference in gaps = 2% − 0.5% = 1.5%. X has the advantage in £ (relatively), Y in $.
Total saving = 1.5% per year on the principal. In $ this is 1.5% × $15 million = $225,000 a year; in £ it is 1.5% × £10 million = £150,000.
Without a fee, an equal split gives each firm 0.75%.

Answer: The total annual saving is 1.5%, about £150,000 (or $225,000). Each firm gains 0.75% a year if shared equally.

Example 2

Using the data above, show the net cost to Firm X (which wants $ debt) and Firm Y (which wants £ debt) if the saving is shared equally and no fee is charged.

Show the solution

X borrows £10 million at 6% in the market where it has the advantage. Y borrows $15 million at 7.5%.
X's direct $ cost is 8%. With a 0.75% share of the saving, X's target net $ cost is 8% − 0.75% = 7.25%.
Y's direct £ cost is 7%. Its target net £ cost is 7% − 0.75% = 6.25%.
Interest on X's £ loan: 6% × £10 million = £600,000. Interest on Y's $ loan: 7.5% × $15 million = $1,125,000.
X pays Y interest on the $15 million at 7.25%, which is $1,087,500 a year. Y pays X the £ interest of £600,000 on X's loan plus nothing more than Y's target needs, so Y's net £ cost is 6.25% of £10 million = £625,000.
Check: Y pays £625,000 to X, and X passes £600,000 to its lender, so X keeps £25,000, equal to 0.25%. Settle these through the swap terms by adjusting rates: X pays $1,087,500 to Y; Y pays £600,000 to X's lender; Y bears the extra £25,000 as its net cost. Y receives $1,087,500 and pays $1,125,000 to its lender, a net $37,500 cost, worth about £25,000 at $1.50. This confirms Y's net cost of £625,000.
At the end, X and Y re-exchange principal at $1.50 per £1: $15 million and £10 million.

Answer: X ends with $ debt at a net 7.25%, Y with £ debt at a net 6.25%, each saving 0.75% a year. Principal is re-exchanged at $1.50 per £1 at maturity.

Exam tips

Write what each party wants in one line before any numbers. Marks often depend on getting the direction right.
Show the swap as a short diagram of arrows with rates, and then explain it in words. It makes your answer clear to the marker.
Always comment on risks: counterparty default, the loan still being owed, and loss of favourable currency moves.
Use professional skills marks by advising the board: say whether you would recommend the swap compared with a forward or money market hedge, and why.
Be able to contrast currency swaps with interest rate swaps and with forwards in a few sentences.

Practice questions from The use of financial derivatives to hedge against forex risk

Currency Swaps in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Currency Swaps: frequently asked questions

What is a currency swap in simple terms?

It is an agreement to exchange loan principal and interest in two currencies for a fixed period. The exchange rate is fixed at the start. This removes exchange rate risk on long-term borrowing.

How is a currency swap different from an interest rate swap?

A currency swap involves two currencies and normally exchanges principal at the start and end. An interest rate swap works in one currency and normally exchanges only interest, such as fixed for floating.

Why use a currency swap instead of a forward contract?

Forward contracts are usually not available for long periods. A swap can cover many years, so it suits long-term loans or foreign income. It can also lower borrowing costs through comparative advantage.

How do you calculate the gain from comparative advantage?

Find each firm's rate difference between the two currencies. Subtract the smaller difference from the larger. The result is the total saving, which is shared after deducting any bank fee.