A Currency Swap is a pact between two countries that allows trading in their own currency and payments to import and export trade at pre-determined exchange rates without bringing in a third currency.
How does a Currency Swap Agreement work..??
At the start of a swap, central bank 1 sells a specified amount of currency A to central bank 2 in exchange for currency B at the prevailing market exchange rate..
Central bank 1 agrees to buy back its currency at the same exchange rate on a specified future date.. Central bank 1 then uses the currency B it has obtained through the swap to lend on to local banks or corporations..
On the specified future date that the swap unwinds and the funds are returned, central bank 1, which requested activation of the swap, pays interest to central bank 2..
While the terms of swap agreements are designed to protect both central banks involved in the swap from losses owing to fluctuations in currency values, there are some risks that a central bank may refuse, or be unable, to honor the terms of the agreement..