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Strategic Financial Management · Swaps

Currency Swaps: How Cash Flows Work for CMA Final

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 fixed period. Principal is usually exchanged at the start at the spot rate and handed back at the end at the same rate. To solve it, list the three sets of flows (start, interest dates, maturity) for each party.

Understand Currency Swaps

A currency swap is a contract in which two parties swap a loan in one currency for a loan in another. One party pays interest and principal in currency A. The other pays interest and principal in currency B. The two principal amounts are set as equivalent at the spot rate on the start date.

Why would anyone do this? Say an Indian company wants US dollars for a project abroad, but US lenders do not know it well and charge more. A US firm in India has the opposite problem. Each borrows in its home market, where it is well known and gets a cheaper rate, and then they swap. Each ends up with the currency it needs at a lower cost. This is the 'raising foreign funds' use.

The second use is hedging. If an Indian company has a dollar loan, a fall in the rupee raises its repayment cost in rupees. By swapping, it receives dollars from the bank to pay its lender and pays the bank in rupees on pre-agreed terms. The rupee outgo is now fixed and known.

A currency swap has up to three stages. First, an initial exchange of principal at spot (sometimes skipped if each party already holds its loan). Second, periodic interest payments, each party paying interest on the principal of the currency it owes, at the rate agreed. Third, a final re-exchange of principal at the same spot rate used at the start, so exchange rate movements do not change the principal.

The key difference from an interest rate swap: in an interest rate swap both legs are in the same currency, only interest is exchanged, and the principal is notional and never changes hands. In a currency swap the legs are in two currencies and the principal is actually exchanged. Because of that, currency swaps carry exchange rate exposure on interest flows, unless those flows are also fixed in the swap terms.

Key rules to remember

Principal in the second currency
Principal B = Principal A × Spot rate (B per unit of A) at start
Fixed at the start date. The same amounts are used for the final re-exchange.
Periodic interest on a leg
Interest = Principal of that currency × Swap rate for that leg × (months ÷ 12)
Each leg pays interest only on its own currency principal. Use the rate type given: fixed or floating.
Final cash flow on a leg
Final payment = Principal + Last period's interest
Principal is returned at the original spot rate, not the rate at maturity.
Rupee value of a foreign flow
₹ value = Foreign currency amount × Spot rate on the payment date
Use this to compare the swapped position with the unhedged position.
Net cash flow for a party
Net = Receipts on the swap − Payments on the swap (in one common currency)
Convert both to rupees before netting. Never net dollars against rupees.

How to solve Currency Swaps questions

Use this order for any currency swap question. It keeps the three stages and the two currencies apart, which is where marks are lost.

  1. 1Identify the parties and the two currencies. Note which leg each party pays and which it receives.
  2. 2Fix the principals. Convert one principal into the other at the spot rate on the start date.
  3. 3Write the initial exchange. Show who gives what and who receives what. If the question says no initial exchange, skip this step.
  4. 4Compute periodic interest on each leg using its own principal, its own rate and the period fraction.
  5. 5Write the final flow: last interest plus the principal, re-exchanged at the original rate.
  6. 6Convert foreign flows to rupees at the spot rate on each date, if the question gives future spot rates.
  7. 7Net the flows, or compare with the unhedged position. Find the effective cost or saving.
  8. 8State the conclusion in one line: effective cost, gain or loss, and whether the swap hedged the risk.

Quickest way: Three-column cash flow table

When to use it: Use it when the question gives rates and principals and asks for cash flows, effective cost or net gain over several years. It works for plain fixed-for-fixed swaps.

  1. Draw columns for Start, Each interest date and Maturity. Make one row per party.
  2. Fill the Start column: principal paid and received, converted at the spot rate.
  3. Fill the interest column: principal × rate for each currency. The same amount repeats every period.
  4. Fill Maturity: interest column amount plus principal on each leg.
  5. Convert only if asked, and convert before netting.
  6. Check: at maturity, each party's principal received and paid must match its start amounts, reversed.

Common mistakes in Currency Swaps

  • Applying the maturity spot rate to the principal re-exchange.

    Students treat the swap like a forward-looking conversion at the current rate.

    Fix: The principal is re-exchanged at the same rate as at the start. Only the unhedged position uses the maturity spot rate.

  • Calculating interest on the wrong principal.

    Both legs get mixed up, so the rupee rate is applied to the dollar principal.

    Fix: Label each leg with its currency, principal and rate before calculating.

  • Netting dollars against rupees directly.

    Students subtract numbers without converting them first.

    Fix: Convert to a single currency at the relevant date's spot rate, then net.

  • Treating a currency swap like an interest rate swap, with only a net interest difference.

    Both are called swaps and the interest rate swap is more familiar.

    Fix: Remember that a currency swap exchanges principal in two currencies. Netting of interest applies only if both legs are in the same currency.

  • Dropping the initial exchange from the cash flow list.

    Students start the table from the first interest date.

    Fix: Always check whether the question mentions an initial exchange. If it does, show it as the first row.

  • Forgetting the last interest payment at maturity.

    The principal is the large number, so the interest looks like an afterthought.

    Fix: Write the maturity flow as principal plus that period's interest, every time.

Worked examples

Example 1

An Indian company X and a US company Y enter a 3-year currency swap. Spot rate is ₹82 per USD. X receives USD 10,00,000 from Y and pays the rupee equivalent to Y at the start. Each year X pays Y interest at 5% on the USD principal and receives from Y interest at 8% on the rupee principal. Principals are re-exchanged at maturity. Show X's cash flows. Also, if the spot rate at the end of year 3 is ₹85, find X's net rupee outflow in year 3 on the swap.

Show the solution
  1. Rupee principal = USD 10,00,000 × ₹82 = ₹8,20,00,000.
  2. Start (X): receives USD 10,00,000 and pays ₹8,20,00,000.
  3. Annual USD interest paid by X = 10,00,000 × 5% = USD 50,000.
  4. Annual rupee interest received by X = 8,20,00,000 × 8% = ₹65,60,000.
  5. Years 1 and 2 (X): pays USD 50,000 and receives ₹65,60,000.
  6. Year 3 (X): pays USD 10,00,000 + 50,000 = USD 10,50,000. It receives ₹8,20,00,000 + ₹65,60,000 = ₹8,85,60,000.
  7. Rupee value of USD 10,50,000 at ₹85 = 10,50,000 × 85 = ₹8,92,50,000.
  8. Net year 3 = ₹8,92,50,000 − ₹8,85,60,000 = ₹6,90,000 outflow.

Answer: X pays USD 50,000 and receives ₹65,60,000 in years 1 and 2. In year 3 it pays USD 10,50,000 and receives ₹8,85,60,000. At a ₹85 spot rate, its net rupee outflow in year 3 is ₹6,90,000.

Example 2

An Indian company has taken a 2-year USD 20,00,000 loan at 6% annual interest, repayable in full at the end of year 2. Spot rate is ₹80 per USD. It enters a swap with a bank: at the start it gives the USD to the bank and receives ₹16,00,00,000. Each year the bank pays it USD 6% interest on USD 20,00,000 and it pays the bank 8.5% on ₹16,00,00,000. Principals are re-exchanged at maturity. Show the company's cash flows and compare year 2 with the unhedged position if spot at the end of year 2 is ₹86. Also compare year 1 interest if spot is ₹83.

Show the solution
  1. Annual USD interest = 20,00,000 × 6% = USD 1,20,000. This is received from the bank and paid to the lender, so it nets to nil in dollars.
  2. Annual rupee interest paid to the bank = 16,00,00,000 × 8.5% = ₹1,36,00,000.
  3. Year 1 swapped cost = ₹1,36,00,000. Unhedged, USD 1,20,000 × 83 = ₹99,60,000.
  4. Swap costs ₹1,36,00,000 − ₹99,60,000 = ₹36,40,000 more in year 1.
  5. Year 2 loan repayment = USD 20,00,000 + 1,20,000 = USD 21,20,000. The bank pays exactly this amount to the company.
  6. Year 2 rupee payment to the bank = ₹16,00,00,000 + ₹1,36,00,000 = ₹17,36,00,000.
  7. Unhedged year 2 cost = 21,20,000 × 86 = ₹18,23,20,000.
  8. Saving in year 2 = ₹18,23,20,000 − ₹17,36,00,000 = ₹87,20,000.

Answer: The swap converts the dollar loan into a rupee loan at 8.5% on ₹16,00,00,000, so the cash outflow is fixed at ₹1,36,00,000 a year and ₹17,36,00,000 in year 2. At the assumed rates, the swap costs ₹36,40,000 more in year 1 but saves ₹87,20,000 in year 2. The gain comes from the rupee weakening to ₹86. If the rupee had strengthened instead, the swap would have cost more, but the company would still have had certainty.

Exam tips

  • Draw the cash flow table first, even for a 2-mark MCQ. The right answer is usually one line of it.
  • Check the rate the question gives for each leg and which currency it applies to. Questions often give two rates and ask for only one leg.
  • If the question says 'hedge', compare the swap position with the unhedged position at the future spot rate and state the gain or loss clearly.
  • In descriptive answers, state the use (cheaper funds or hedging), then the three stages of flows, then a note that currency swaps exchange principal while interest rate swaps do not.
  • Show conversions in rupees with Indian grouping and label every figure as USD or ₹ so the examiner can follow your working.

Practice questions from Swaps

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

How does a currency swap work?

Two parties agree to exchange loans in two currencies. They swap principals at the start at spot, pay each other interest in the respective currencies during the term, and swap the principals back at the end at the same rate.

What is the difference between a currency swap and an interest rate swap?

An interest rate swap involves one currency, exchanges only interest (usually fixed against floating), and keeps the principal notional. A currency swap involves two currencies, and the principal is actually exchanged at the start and the end.

At what rate is principal re-exchanged in a currency swap?

It is re-exchanged at the rate agreed at the start, usually the original spot rate. That is why the swap protects against exchange rate changes on the principal.

Is there an initial exchange of principal in every currency swap?

No. Many swaps have one, but if each party already holds the loan it needs to service, the initial exchange can be skipped. Read the question to see which applies.