A cross currency swap is a financial agreement between two parties to exchange principal amounts in two different currencies, often at both the beginning and the end of the swap period. Additionally, they agree to exchange interest payments periodically on the principal amounts exchanged. These swaps are commonly used by companies to hedge against currency fluctuations and manage exposure to foreign exchange risk.

For example, a company in the United States might enter into a cross currency swap with a European firm. The U.S. company could exchange a specified amount in USD for an equivalent amount in EUR at the agreed-upon exchange rate. Throughout the term of the swap, they would exchange interest payments based on the respective currencies’ principal amounts. Then, at the end of the agreed term, the principal amounts are swapped back at the original exchange rate.

This type of financial derivative can be a useful tool for companies engaged in international operations, ensuring that currency movements do not adversely impact their financial performance. However, this instrument involves risks, such as credit risk and market risk, which participants should carefully assess.