Currency Swaps Exchange Interest and Principal in Different Currencies

Summary

The document addresses whether different fixed rates in a fixed-for-fixed currency swap create a free return for one counterparty. Its explanation emphasizes that each party pays interest on a principal denominated in its currency and returns that principal at maturity. The apparent rate gap therefore cannot be treated as a standalone gain on an unchanged principal.

The answer attributes much of the difference between the USD and JPY rates to distinct central bank policies, rather than simply to differences in the counterparties’ credit ratings. This is a brief conceptual clarification, not a full account of swap valuation: it does not discuss initial principal exchanges, exchange rates, collateral, credit risk, or how market pricing determines the contractual terms. Readers should use it to correct the basic cash-flow intuition, not as a complete pricing framework.

Key ideas

• Each party pays interest on principal denominated in its currency.
• The principal amounts are repaid at maturity, so the interest rate gap is not a free yield by itself.
• Differences in central bank policies help explain differences between currency interest rates.
• Counterparty credit ratings alone do not explain the stated rate discrepancy.

Tags

# fixed-for-fixed currency swap interest rate discrepancy


# fixed-for-fixed currency swap interest rate discrepancy












I was going through some basic stuff and I found something that I couldn't really make sense of. Lets say that two entities A and B engage in a currency swap. A pays 3% on USD, while B pays 2% on JPY. While I understand that the discrepancy in the interest rate stem from the fact that A and B might have different credit ratings from the US and Japan, it seems to me that this would lead to an arbitrage opportunity. If we cut out the middleman, wouldn't this mean that B will be earning a free percentage on the principle? Or, is my understanding of currency swaps and comparative advantage just bogus?

Criticism is welcome as long as they are constructive. I would appreciate any input.

## Answer by dm63 (score 2, accepted)

https://quant.stackexchange.com/a/30535

I think your understanding of currency swaps may be incorrect. A is paying 3 pct interest on the USD principal and then the whole USd principal at the maturity. Likewise B pays both interest and principal in Yen. The interest rate differential is mostly due to different central bank policies in US and Japan, not credit ratings.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.