Can someone explain the actual cash flow mechanics of a currency swap step by step?

Currency swaps differ from plain-vanilla interest rate swaps in three crucial ways: (1) principals ARE exchanged at inception and maturity, (2) interest payments are in two different currencies, and (3) there is FX risk layered on top of interest rate risk.

The Three Phases

Setup: Pinnacle Bank needs EUR funding, and Evergreen Corp needs USD funding. The spot rate at inception is EUR/USD = 1.0870 (i.e., $1.087 per euro). They agree to a 3-year currency swap:

• Notional: $10 million vs. EUR 9.2 million (= 10M / 1.087)
• Pinnacle pays 3.50% on the EUR notional
• Evergreen pays 4.50% on the USD notional

Phase 1 — Initial Exchange (Day 0):

Pinnacle hands $10M to Evergreen. Evergreen hands EUR 9.2M to Pinnacle. Each party now has the foreign currency it needs.

Phase 2 — Annual Coupon Swaps (Years 1, 2, 3):

• Pinnacle pays Evergreen: EUR 9.2M x 3.50% = EUR 322,000
• Evergreen pays Pinnacle: $10M x 4.50% = $450,000

Note: these are NOT netted (unlike IRS in the same currency) because they are in different currencies.

Phase 3 — Final Exchange (Year 3):

Principals are re-exchanged at the ORIGINAL exchange rate, regardless of where spot FX is at maturity. Pinnacle returns EUR 9.2M; Evergreen returns $10M.

Valuation mid-life works exactly like an IRS — treat each leg as a bond in its respective currency, convert to a common currency at the current spot rate, then subtract.

This is heavily tested in FRM Part I, especially the distinction between currency swaps and cross-currency basis swaps.

Join our FRM community for more derivatives discussion.