The Currency Swap: Where the Principal Really Moves

A currency swap is a single agreement in which two parties hand each other principal and interest in two different currencies. The principal is not a multiplier here. The amount is handed over at the start, and handed back at the end at the rate written into the agreement on day one. In between, each side pays interest in the currency it received.

One sentence has carried the treatment of this subject so far, and here that sentence gets broken. The rule was that the headline figure in an arrangement of this kind never changes hands. The figure is a multiplier. A multiplier turns a rate into rupees and then sits there for the whole life of the document, untouched. Meanwhile the difference between two schedules of payments moves back and forth. The rule is correct, and it is worth learning properly. And the moment a cross currency agreement is put in front of somebody who learned it properly, it stops being correct.

In a cross currency arrangement the principal genuinely moves, twice: once at the start, and once again at the end. Not as an accounting entry, not as a figure applied to a rate, but as money that leaves one party and arrives at the other. A reader who carries the earlier rule across without checking will read the most important line in the document as though it were decoration.

The situation comes before the instrument. An instrument only makes sense once it is clear what it was reached for. Two businesses are sitting in different places, and each of them has money in a currency it cannot use for what it actually has to pay. Neither wants to sell what it holds. Neither wants to borrow from a stranger. But each holds exactly what the other needs, and each needs exactly what the other holds.

The same trade happens on any street. Two shopkeepers run stalls in two different cities, and each is holding a float of change that belongs in the other city: coins that spend perfectly well two hundred kilometres away and buy nothing where they are standing. Each shopkeeper could go to a moneychanger, hand over the float, take back the local coin and pay a spread twice, once on the way out and once on the way home. Or the two of them can simply swap floats for a year, use each other's money for the whole season, pay each other a little every month for the use of it, and swap the floats back at the end on terms they settled on the first day. Nobody sold anything. Nobody lent to a stranger. And for a year each shopkeeper has been holding the money that works where they stand.

The swap of floats is the whole shape of a currency swap, and almost nothing about it changes when the floats become large and the two parties become companies. One thing does change: the terms of the swap back are written down on the first day rather than left to whatever the moneychanger is quoting at the end. Those written terms carry the weight of the whole arrangement.

Everything below runs on one invented agreement between two parties, Chitrakoot Cements Limited and Saranga Capital Limited, both of which appear earlier in this material. In the arrangement on rates alone covered earlier, Chitrakoot Cements is the fixed payer, paying 7.20 per cent a year on a notionalThe figure two rates are applied to inside an agreement. It turns a percentage into rupees and never changes hands, which is exactly why it is called notional rather than principal. of Rs 1,000 crore and receiving the floating benchmark, and Saranga Capital is the floating payer, paying the floating benchmark and receiving the fixed rate.

No rupee amount for the cross currency arrangement can be computed at all. Two readings would have to exist before a single rupee could be computed here: an exchange rate between the two currencies on a stated date, and a rate for each currency with its period attached. Neither of those readings exists. The arrangement is described exactly instead, and the amounts are left as amounts. Where a figure would normally sit there are instead the words that say what would have to be known before a figure could go there.

What is a currency swap, and what does it change about the arrangement already covered?

The general form changes in exactly one respect. Two parties. One agreement. Two schedules of payments running in opposite directions. So far this is the arrangement already covered. The one change is this: the two schedules are written in two different currencies, and once that is true, everything else in this guide follows without a single new rule being invented.

Because the two sides are in different currencies, the word cross currencyA description of any arrangement whose two sides are written in two different currencies, so that each side is paying and receiving in a different unit of money. gets attached to the arrangement, and it is doing real work rather than decorating the name. The words say that nothing inside the agreement can be set against anything else without a rate to convert with.

Here is the shape, plainly. At the start, each side hands the other an amount of money in the currency it holds. During the arrangement, each side pays interest on the amount it received, in the currency it received. At the end, the two amounts are handed back, in the same two currencies, at the terms written into the agreement on the first day. Three moments, and something physically moves at every one of them.

The word for the amount that moves is principalAn amount that genuinely changes hands, as against a notional, which is only ever applied to a rate and stays where it is written., and it is not a synonym for notional. A principal is the opposite kind of object. A notional is a figure the document computes on. A principal is a figure the document moves. Reading a cross currency agreement and calling the top line a notional out of habit is not a slip of vocabulary. The mistake claims that nothing has to leave the account, and it makes that claim about a document whose whole point is that something does.

Notice what has not changed. A reader expecting the arrangement to become a different animal will look past the parts that stayed the same. There are still exactly two schedules of payments. Neither side has bought anything from the other. Neither has issued anything to the other. Neither is a lender to the other in the ordinary sense. Each has handed over as much as it has taken in. The agreement is still one document with two sides to it, and the parties are still each other's counterpartyThe specific named party on the other side of a privately agreed arrangement. Not a market and not an exchange: one identified party, who either performs or does not. rather than participants in a market.

The change is that the arrangement now has physical consequences on day one. In the version on rates alone, the day of signing produces no cash movement whatsoever: two schedules begin, the first payment is some way off, and nothing leaves anybody's account. Here, the day of signing produces the largest cash movement in the entire arrangement, in both directions at once.

Which amounts actually change hands, and when?

Three moments, and they are worth holding as three. The entire difference between this arrangement and the one already covered sits in the first and the third. A reader who holds only the middle one has not left the arrangement on rates alone.

The first moment is the initial exchangeThe handover of the two principal amounts at the start of a cross currency arrangement, each side giving the currency it holds and taking the currency it wants.. On the day the arrangement begins, Chitrakoot Cements Limited hands Saranga Capital Limited an amount in the currency it holds, and Saranga Capital hands back an amount in the other currency. Both movements happen. Neither is notional. From that day, each side is using money it did not have the day before, and the money it did have is sitting with somebody else.

The second moment is not a moment at all but a rhythm that runs for the life of the agreement. On each payment date, each side pays interest on the amount it received, in the currency it received. Hold on to that sentence. The arrangement stops being strange right there: each side is paying for the use of the money it is actually using, in the money it is actually using. Chitrakoot Cements received one currency and pays interest in it. Saranga Capital received the other currency and pays interest in that.

The third moment is the final exchangeThe handover back of the two principal amounts at the end of the arrangement, on terms written into the agreement on the first day rather than settled at the end.. On the last day, the two amounts go back the way they came. Chitrakoot Cements returns what it received. Saranga Capital returns what it received. And they do it on the terms written into the agreement on day one, not on whatever terms are available on the day.

The first and the third moment have no counterpart at all in an arrangement on rates alone, and the second moment is the only one that looks anything like it. Saying it in those words explains why the earlier rule felt so complete. If the only moment in the picture is the middle one, then a headline figure that never moves is the whole truth. With the two ends added, it stops being the truth at all.

Now the part readers assume away, almost every time, and it takes ten seconds to state and a lot longer to unlearn. The two interest payments here are in different currencies, so they cannot be netted the way two amounts in one currency can. In the arrangement on rates alone, the fixed leg and the floating leg both landed in the same money on the same date, so one could be subtracted from the other and a single difference could move. Here, subtracting one from the other is not a matter of preference or of market convention. The subtraction cannot be performed at all without a rate to convert with. Two amounts in two currencies do not have a difference until somebody supplies the rate that gives them one.

So both interest payments happen. Both directions. Every payment date. The tidy single transfer that the earlier arrangement produced, where two schedules collapsed into one movement, does not survive the crossing into a second currency, and it does not survive it for a reason that has nothing to do with the parties or their preferences.

Why does the principal move here when it does not move in an arrangement on rates alone?

The reason is short, and it is not complicated once it is said in the right order.

In an arrangement on rates alone, both legs are computed on the same figure, in the same currency. Watch what that does. The fixed leg is Rs 1,000 crore of notional at 7.20 per cent a year. Over one full first period the fixed leg comes to Rs 72,00,00,000/-, or Rs 72.00 crore gross. The floating leg is that same Rs 1,000 crore at a first period reading of 6.00 per cent a year, and it comes to Rs 60,00,00,000/-, or Rs 60.00 crore gross. Both figures are built from the identical base. Subtract one from the other and the base disappears. The remainder is Rs 12,00,00,000/-, or Rs 12.00 crore, and that is the only amount that ever travels between the two parties in that first period. The gross of Rs 132.00 crore collapses to a net of Rs 12.00 crore, exactly eleven times smaller, and the net divided by the notional is 12 divided by 1,000, or 1.2 per cent exactly.

Turned around, that gives the sentence that made the earlier arrangement work. The notional divided by the net is 1,000 divided by 12, or 250 divided by 3. The answer is not 83.33. The answer is 83.33 recurring, and the difference matters enough to write down: 83.33 multiplied by Rs 12.00 crore is Rs 999.96 crore, and that is Rs 4,00,000/- short of the notional. The ratio is a rounding rather than an equality, and it belongs in the same breath as its base. A ratio without its base is a number with nowhere to stand.

Now hold the reason the base disappeared. The base cancelled because it was the same base on both sides. Both legs were multiplying it. Nothing had to move. The two amounts were built out of one figure already sitting in the document, and the document could simply compute the gap.

Now go across to two currencies and see what has gone. There is no single figure that both legs multiply. There are two amounts, in two different units of money, and there is no operation that turns one into the other unless somebody supplies a rate. There is nothing to cancel, so nothing cancels, and what cannot cancel has to move. Each side genuinely needs the other's money, in the other's money, and the only way to have it is to be handed it.

The reason generalises well past this arrangement. Carry it rather than memorise it. An amount moves when the two sides need different things, and an amount stays where it is written when both sides are computing on the same thing. Any arrangement can be put against that sentence. If both legs are being worked out from one figure in one currency, a difference moves and the figure stays put. If the two sides are working in different units, the amounts themselves have to travel.

The household version is a lending library rather than a bank. Two neighbours each own a ladder, and neither ladder is the wrong ladder, so nothing is exchanged: they simply compare who used whose for more days and one of them buys the other a coffee. The ladders are the arrangement on rates alone: same object on both sides, so only the difference moves. Now one neighbour has a ladder and the other has a pressure washer, and each needs what the other holds. There is no way to settle that with a coffee. The ladder physically goes across the fence, the pressure washer physically comes back, and at the end of the month each item goes home. Nothing about that is a financial insight. Swapping is just what happens when the two sides are not the same kind of thing.

How Currency Swaps Exchange Currency Exposure, and what is each side left carrying?

Take each side twice, once before and once after, and be slow about it. Here the arrangement stops being a diagram and starts being something a party has to live with for years.

Before the arrangement, each side held money in a currency it did not want, and owed money, or expected to spend money, in a currency it did not hold. The mismatch is the reason parties reach for this arrangement. Nothing about it is exotic. A household that earns in one city and is paying rent in another has the same problem in a smaller frame: the money arrives in a form that does not fit the obligation, and every month somebody pays a conversion cost to make it fit.

After the arrangement, each side holds the currency it wanted. Chitrakoot Cements Limited is using money that matches what it has to spend. Saranga Capital Limited is doing the same on its side. Each pays interest in that currency, so the cost of the arrangement lands in the same money as the need it was entered for. And each carries a commitment to hand the amount back at the end.

Now the part that gets taught badly, and it gets taught badly by merging. After the arrangement, three separate exposures exist where a careless reading sees one, and keeping them apart is most of the skill.

The first is the rate paid on each currency. Each side is paying interest on what it received, at whatever the rate for that currency is under the agreement, and those are two different rates on two different currencies. Neither rate appears here, for the same reason as throughout: no rate in a second currency exists behind this guide.

The second is the rate at the final exchange. The two amounts go back on terms fixed on day one, and what those terms turn out to be worth to each side depends on where the two currencies stand against each other on that later date. Nobody knows that today, and no figure for it is printed anywhere.

The third is whether the other side is still there to complete it. A cross currency arrangement is privately agreed with one named party on the other side, not a market, and the final exchange is a promise made by that party specifically. The promise is a separate exposure from the two rate exposures, and it does not shrink just because the arrangement has been running smoothly for years.

Then the sentence that the whole block exists for, and it is the one a reader is most likely to get wrong in a meeting. The arrangement changes which currency each side is exposed to. The arrangement does not remove currency exposureBeing affected by where two currencies stand against each other. Being exposed to a different currency is not the same thing as not being exposed at all. from the picture. Somebody who says the arrangement removed their currency exposure has taken three separate things and pressed them into one word, and the word they chose is the one word that is not true. A mismatch was swapped for a match on the money in hand, and a dated obligation in the other currency was created at the same moment.

Say it back in the shopkeeper's terms and it stops being abstract. After the swap of floats, each shopkeeper is holding coin that spends where they are standing, and that was the whole point. But each of them has also promised to hand a specific float back at the end of the season. Neither has stopped caring what the two coins are worth against each other. The shopkeepers have simply moved the question from every day to one day.

What happens at the end, and why is that the step that carries the weight?

At the end, the two amounts are handed back. Not amounts recalculated at the end, not amounts adjusted for anything that happened in between. The same two amounts that were exchanged at the start, on terms written into the agreement on the first day.

Put it plainly. The promise is easy to nod at and hard to feel. Two parties have agreed today what will be handed over years from now, whatever has happened in between. The two parties did not agree a formula to be applied later. Nor did they agree to look at a screen on the last day and settle up on whatever it says. The terms were written down at the start, and both sides then walked forward for years towards a date on which those terms become the ones that apply.

None of that is a forecast. Stop on the word for a moment: the same error gets punished everywhere else in this subject. A rate agreed today for an exchange years from now is not a statement about where the two currencies are expected to be. The agreed rate is arithmetic on what can be borrowed and lent in each currency now, in exactly the way a forward price is arithmetic on a spot price and a financing cost rather than an opinion about the future. Nobody in the room is predicting anything. Both sides are agreeing terms whose whole virtue is that they are known.

Here is the consequence, stated as arithmetic rather than as alarm. The worth of the final exchange to each side depends on where the two currencies stand against each other on that date, and nobody knows that today. One side will look back and find the fixed terms were kinder to it than the terms available on the day. The other will find the opposite. The asymmetry is not a flaw in the arrangement. The asymmetry is the arrangement: certainty about the terms was what the parties bought, and certainty about the terms is not the same as certainty about the outcome. Any figure for that date would need an exchange rate for that date, and no such rate can be known in advance.

And the second consequence is a different animal entirely. If one side is not there at the end, the other side is left holding a currency it did not want, with no agreed way back to the one it did. Being left there is a different kind of trouble from a missed interest payment, and the difference is not one of degree. A missed interest payment is a shortfall on one date. A missing final exchange leaves a party sitting on the wrong money with an obligation somewhere else, and the way back is whatever the open market offers on the day it discovers the problem.

The asymmetry is why the final exchange carries the weight of the whole arrangement. The final exchange is the largest movement and the last movement, and it is the one that cannot be quietly worked around if it fails. Everything in the middle is a rhythm; the end is an event.

What does the ledger look like when no exchange rate exists?

Elsewhere in this material a worked instance carries figures. Here the worked instance carries none, and the shape of it is the teaching. The ledger below records what moves and in which direction at each of the three moments, and it carries no amounts at all. Attaching an amount to any row would take an exchange rate, and no exchange rate has been supplied.

The ledger reads the way an operations person would read it: left to right, one row at a time, asking only what leaves and what arrives. Every cell is filled. Each party's obligation at each moment is completely determined, and it is determined without a single number.

The same ledger reads as a table, and a table is how it would actually arrive on somebody's desk. The direction column is the one that does the work: a reader who can fill that column can operate the arrangement, and a reader who cannot has not understood it however many figures are printed beside it.

Beneath a ledger like that, the useful thing is not an apology. The useful thing is a list of exactly what would fill it in. A reader holding those two items can complete every cell in about four lines of arithmetic. Here is that list, and it has exactly two entries.

Now put that beside the one arrangement this material can work in full, because the contrast is the point rather than an excuse. In the arrangement on rates alone, every reading needed for the first period exists: a notional of Rs 1,000 crore, a fixed rate of 7.20 per cent a year and a floating benchmark reading of 6.00 per cent a year for that period. So the first period can be worked end to end, and it produces Rs 72.00 crore gross against Rs 60.00 crore gross and a net difference of Rs 12,00,00,000/- moving from Chitrakoot Cements Limited to Saranga Capital Limited. The difference between the two is not that one arrangement is simpler. The difference is that one has its readings and the other does not.

Why can no arithmetic be done for a cross currency arrangement at all?

Because two readings would have to exist before a single rupee could be computed for a cross currency arrangement, and neither of them exists behind this guide.

The first is an exchange rate between the two currencies on a stated date. Without it, no amount in one currency can be expressed in the other, no interest payment can be compared with the one coming the other way, and no final exchange can be described in anything but words. The second is a rate for each currency, each carrying the period it applies to. Without those, there is no interest to compute in either direction. A rate without its period is not a rate at all: it is a number that has not said over how long.

Leaving both readings out is a decision, and the only alternative is to invent them. Inventing them is worth looking at for a moment. A treatment picks two currencies, assumes a rate to convert between them, assumes a rate on each, and prints four crisp figures. The four figures now look exactly like figures built from readings that genuinely existed. A reader cannot tell them apart. Six months later, somebody quotes one of them. Fabricated figures enter the world by exactly that route, and the route does not start with dishonesty. The route starts with a teacher wanting the material to look complete.

So the shape of what is missing is given instead, precisely enough to be supplied. With an exchange rate and its date, and a rate for each currency with its period, every cell in that ledger becomes computable in about four lines. Until then, the ledger stays in words, and it is better for it. A reader who understands direction without amounts understands the arrangement. A reader who has memorised four invented amounts understands nothing.

There is a habit worth taking from this, and it is the same one built up earlier. When a document, a note or a screen carries a figure attached to something like this, the questions to ask are which readings produced it and where those readings came from. If the answer is thin, the figure is thin, whatever it looks like. A number with nothing behind it is not a better teaching aid than an honest gap: it is a worse one, because it cannot be checked.

When is the headline figure a notional, and when is it a principal?

The naming trap catches careful people rather than careless ones, and that is exactly why it is worth a section of its own.

In an arrangement on rates alone, the figure at the top of the document is a notional. Rs 1,000 crore sits there and stays there. Calling it principal is wrong. Principal is money that moves, and this figure never does. The discipline was drilled earlier for a good reason: a reader who calls that figure principal will read a Rs 1,000 crore arrangement as a Rs 1,000 crore exposure, when what actually moved in the first period was Rs 12.00 crore.

In a cross currency arrangement, the figure at the top of the document is principal, and calling it a notional is exactly as wrong, in exactly the opposite direction. The figure is handed over at the start and handed back at the end. Principal is money, and it travels twice.

So the discipline is not a rule about which word to prefer. The discipline is a rule about where to look. Read the document before choosing the word. If the figure is exchanged at the start and exchanged back at the end, it is principal. If it only ever multiplies a rate, it is a notional. Nothing about the size of the figure settles which, nothing about the length of the arrangement settles it, and nothing about how the arrangement is described in a summary line settles it either. Only the clause governing the start and the end settles it.

Two habits follow from that, and they are cheap. The first is that on meeting a swap of any kind, the clause to find, before anything about rates is read, is the one that says what happens to the headline figure at the start and at the end. The clause settles the word. The second is that anybody writing about one puts the word and its consequence in the same sentence: a notional that never becomes a cash flow, or a principal that is exchanged at the start and back at the end. A reader who is handed the word alone will import whichever meaning they learned first, and half the time that will be the wrong one.

How does somebody actually read one of these, and what do they do first?

The mechanism is not the job. Below is how the idea gets handled by people who deal with these arrangements as part of ordinary work, and every step is a reading habit rather than a decision about whether to be in one.

1. A treasury team writes the two exchange dates into the calendar before it writes anything else. Not the interest dates, which will look after themselves, and not the rates. The first day and the last day. On those two days a large amount of money has to be in the right currency in the right place. An arrangement that is perfectly understood and not diarised fails on exactly one day, and it is the day everybody knew about.
2. A credit analyst reads the other side before the arithmetic, and reads the last day hardest. The final exchange is a promise made by one named party. It is not owed by a market and it cannot be closed out with a screen. So the analyst is asking a question about that party over the whole length of the arrangement, not about it today, and the answer gets longer and less comfortable the longer the arrangement runs.
3. A lender looking at a borrower checks whether the two sides of the swap match the two sides of the underlying need. Same currencies, same amounts, same dates, same length. Where they match, the borrower has moved its money into the shape of its obligations. Where they do not, something is left over, and that leftover is what the reading exists to find. A swap that is nearly the right size is not a smaller version of the right one.
4. Anybody writing an internal note states what the headline figure does, in words, in the first line. Handed over at the start and back at the end, or applied to a rate and never moved. Seven or eight words prevent almost every error described here, and they cost nothing. A note that opens with a figure and no verb is a note that will be misread by somebody who was not in the room.
5. The household version: a person sending money home every month reads the conversion, not the amount. Somebody working in one place and supporting a household in another meets this whole subject in miniature every month, because the money arrives in one currency and is needed in another, and the terms of that conversion decide what actually lands. Anybody who has watched a fixed monthly amount arrive as a different sum at the other end has felt precisely what the final exchange is about, at a scale they can see.

Who sets the conditions on entering one of these?

Three conditions sit over Chitrakoot Cements Limited and Saranga Capital Limited in a cross currency arrangement, and all three are named below.

The first is whether a party may enter an arrangement of this kind at all, and against what underlying need. The second is what has to be reported about it, to whom and by when. The third asks what may be moved across a border, in what circumstances and through whom, and that movement is called remittanceThe movement of money across a border. It is not automatic and it is not unconditional: what may move, why, and through whom are all set by an authority.. Remittance has no counterpart at all in an arrangement written inside a single currency.

All three go to the Reserve Bank of India at rbi.org.in. Foreign exchange arrangements in India sit inside that authority's framework, and every one of these three conditions is set there, moves there, and is confirmed there rather than here.

A cross currency arrangement points outward more often than the version on rates alone does, and the reason is structural rather than cautious. An arrangement that crosses currencies touches conditions that an arrangement inside one currency never meets. Money crossing a border is a different act from money moving between two accounts in the same one. A reader who assumed the two arrangements carry the same conditions would be wrong before they started, and would be wrong in the most expensive direction: assuming permission where permission is a question.

Every row in the sheet below is empty. Each condition is set by the authority printed inside the row, and each one moves, so any written out version would be wrong rather than merely out of date on the day it changed.

Does any of this suggest that anybody ought to enter one?

No, and the reason is worth stating plainly.

Understanding where the principal moves is a reading skill. The skill allows a document to be opened and read correctly for what leaves and what arrives and on which dates, and it is useful whether anything is ever signed or not. Reading a swap is the same kind of skill as reading a rent agreement: valuable in itself, and completely separate from whether the particular flat suits the tenant.

Whether an arrangement of this kind fits a particular reader depends on facts not available here. Which currency they already hold, and how much of it. Which currency they owe in, and over what period. Whether the two line up in amount and in date or only roughly. Their own position, specifically, if the other side is not there at the end. And the cost of the alternatives available to them, a question about their own position rather than about the instrument. How the arrangement works is one question. Whether a particular party should be in one is a different question, and it cannot be answered without every fact just listed.

How one of these arrangements turned out against another is not knowable in advance, and no outcome is settled until the last day of it. A description of an obligation is not a prediction, and the three moments drawn above describe what the two sides have promised each other rather than what either will be glad about later.

Chitrakoot Cements Limited and Saranga Capital Limited are invented, and so are the notional of Rs 1,000 crore, the fixed rate of 7.20 per cent a year and the first period benchmark reading of 6.00 per cent a year.
Educational material. Not advice on any investment, tax, budget or market position.