What is currency swapping?

With the recent development in the Chilean-Chinese front on economy and trade as the two countries signed a Currency Swapping agreement, many people kept wondering what that meant.

China being number 1 and Chile trailing far behind at number 40 in world rankings, the agreement is considered to be a divine intervention for the trade and economy of the country.

What is currency swapping?

As the term describes, it can be described simply as a way to borrow the interest or principal in one currency for the same in another country. It is considered to be a foreign exchange transaction and is not required by law to be shown on a country's balance sheet.

[Read: China and Chile sign currency swap agreement]

Investopedia rightly explains it with an example, saying,"suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange."

In other words, currency swaps are over-the-counter derivatives that are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

Advantages

While lowering the affect of the fluctuating economy, currency swapping has the following uses too:

Secure cheaper debt. Here, a component can borrow at the best available rate regardless of currency and then swapping for debt in the desired currency using a back-to-back-loan
To defend against financial turmoil by allowing a country beset by a liquidity crisis to borrow money from others with its own currency.

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