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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.

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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.

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    $\begingroup$ I would add that at one time currency swaps were marketed on the idea that "you can make money via arbitrage of credit ratings differences"; that idea does not have any credibility among serious observers today. Some old books still mention it as a rationale for currency swaps, though. $\endgroup$
    – nbbo2
    Oct 13, 2016 at 12:06
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    $\begingroup$ In reality short term CCS are used by big international banks to manage their funding in multiple currencies, and longer term CCS are used by pension funds and other institutional investors to hedge FX and i.r. exposure in internationally diversified portfolios. A high credit rating is necessary to participate. $\endgroup$
    – nbbo2
    Oct 13, 2016 at 12:20

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