Cross Currency Swap
A derivative contract between two parties, defining the exchange of obligations based on two interest rate indices with distinct currency values.
What is Cross Currency Swap?
A cross-currency swap is a derivative contract between two parties, defining the exchange of obligations based on two interest rate indices with distinct currency values.
It is a versatile benchmark product that spans multiple currencies simultaneously and falls under the category of interest rate derivatives. Interest rate swaps, foreign exchange rates, and FX swaps influence the pricing of a cross-currency swap.
It also specifies the essential exchange of notional currency in each distinct currency and the terms of notional currency payback throughout the swap.
The most frequent cross-currency swap traded in interbank markets is a mark-to-market cross-currency swap, in which notional exchanges are conducted regularly based on FX rate variations.
This practice ensures that the swap's mark-to-market (MTM) value remains neutral and does not become a significant asset or burden.
Non-MTM cross-currency swaps, although less common, are easier to define as they involve an initial exchange of notional currencies followed by a subsequent exchange at the swap's maturity.
The floating index used in each currency is usually the 3-month tenor interbank offered rate, such as LIBOR in USD, GBP, EURIBOR in EUR, or STIBOR in SEK.
Each set of payments, either in the first or second currency, is referred to as a leg, so a typical cross-currency swap has two legs, each composed of interest payments and notional exchanges.
Essential details, including the notional principal amount, variable abstract schedule, exchange terms, start and finish dates, scheduled dates, selected floating interest rate indices and tenors, and day count standards for interest calculations, are required to establish any cross-currency swap fully.
The basis spread, sometimes called the pricing component, is the agreed-upon amount added to or subtracted from one leg of the swap if the basis spread is negative.
This is usually the domestic leg or the non-USD leg. For example, a EUR/USD cross-currency swap would have the basis spread tied to the EURO-denominated leg.
Key Takeaways
- A cross-currency swap is a derivative contract involving two parties exchanging obligations based on distinct currency values and interest rate indices.
- It consists of two legs, each with interest payments and notional exchanges, and essential components include the notional principal, interest rates, monetary units, and exchange rates.
- Currency swaps involve four major components that enable parties to exchange interest and principal payments, mitigating exposure to exchange rate volatility.
- Cross-currency swaps leverage the comparative advantages of borrowing, allowing parties to secure lower interest rates in their respective currencies.
- They operate by finding a counterparty with access to lower domestic borrowing rates, resulting in a mutually beneficial exchange of debt obligations.
Types of Cross Currency Swap
Cross-currency swaps, as OTC products, can be customized in various ways to meet the specific demands of counterparties.
For example, payment dates may be irregular, the swap notional could be amortized over time, and reset or fixing dates of the floating rate could be erratic. Required break provisions could be put into the contract.
Furthermore, swaps do not necessarily require two floating legs, leading to the naming convention for various types of cross-currency swaps, such as:
- Floating vs. Floating Cross-Currency Swaps: They are the standard, interbank traded instruments. These are basis swaps, the popular name for these over-the-counter (OTC) items. Fixed vs. Floating Cross-Currency Swaps are a popular modification of the benchmark product. Market makers often synthesize or hedge them by trading a float vs. float cross-currency swap and a conventional interest rate swap (IRS) to change the floating leg to a fixed portion.
- Fixed vs. Fixed Cross-Currency Swaps: This is a less specific customization created by market makers exchanging two IRSs in each currency and a float vs. float cross-currency swap.
- Mark-to-Market or Non-Mark-to-Market: In interbank markets, the MTM element and notional exchanges are standard, but customization to omit this is available.
- Non-deliverable Cross-Currency Swap: A non-deliverable cross-currency swap (NDS) is a type where payments in one currency are settled in another using the current FX spot rate. It is commonly used in emerging markets where currencies are unstable, subject to exchange limitations, or non-convertible.
- Embedded options: Unusual customization options may include FX options or swaptions at the maturity of the trade.
Note
Cross-currency swaps are necessary to measure yields on a standardized USD basis, making them a crucial part of contemporary financial markets.
Cross currency swap Components
A currency swap exchanges one currency for another at a fixed rate to lower exposure to risk in the forex market. Two businesses or individuals typically employ a currency swap to lessen their exposure to risk in the foreign exchange market.
One participant in a currency swap seeks to avoid exchange rate volatility by exchanging the principal with the other party and paying the agreed-upon interest rate.
Currency exchange is a way for investors to maximize returns, and a currency swap serves as a hedging arrangement between two parties, potentially resulting in significant income.
Note
In a currency swap, two parties agree—one commits to pay interest and principal at a fixed exchange rate, while the other agrees to a floating variable interest rate.
Currency swaps typically consist of four major components:
- The Principal Sum: This is the amount paid to the opposite side at the start of the currency swap.
- Interest Rates: This is the amount one side pays the other, typically fixed for the contract's duration. The actual interest paid varies with market exchange rates. While the interest rate is set, the amount of interest paid varies according to market exchange rates.
- The monetary unit: In a currency swap, two distinct currencies are used—the base currency in the main component and the counter currency in the interest component.
- The Currency Exchange Rate: It can be set or floating, depending on the selecting party. The base currency determines the fixed rate, while the floating rate is determined by the party with the floating currency.
How Does Cross Currency Swap Work?
Cross-currency swaps leverage the comparative benefits of borrowing, allowing borrowers to secure lower interest rates in their own currency while paying a higher rate when borrowing in foreign currency.
Consequently, cross-currency swaps operate by finding a counterparty in a foreign country with access to lower domestic borrowing rates. The two parties then exchange debt obligations based on the borrowing party's home rate.
Let's understand this by taking an example below:
| Dollars | Swiss Francs | |
|---|---|---|
| Group A (American) | 6% | 10% |
| Group B (Switzerland) | 5% | 11% |
In this example, Group A has a comparative advantage in borrowing Swiss francs, but Party A needs to borrow dollars.
Conversely, Party B has an advantage in borrowing dollars but needs Swiss francs. Both parties can secure more favorable rates through a cross-currency swap.
The quality spread differential can be used to calculate the possible gain from trade (QSD).
QSD = Dollar (group A - group B) – Swiss franc (group A – group B)
QSD = (6% – 5%) – (10% – 11%) = 2%
The two parties can benefit from a 2% combined gain through a cross-currency exchange.
Here is an illustration of a cross-currency basis swap between an American counterparty and a British counterpart using the USD/pound exchange rate.
Assume the British party wants to borrow $150 million and lends £50 million to the American party. The current spot rate is $3 per pound. The British party gets an introductory swap price and interest payments from its counterparty in pounds for the length of the contract.
Interest payments are typically made quarterly. In turn, it pays the notional amount in USD to the American counterparty at the agreed-upon interest rate. Both parties can benefit from better rates if they enter a cross-currency swap.
Upon contract expiration, the British business will pay the full principal sum of $150 million to the American corporation at the prevailing exchange rate of £50 million.
Benefits of Cross Currency Swap
There are several advantages to using currency swaps. Here are some primary benefits of currency swaps:
- It facilitates lower-risk exposure: As mentioned earlier, the primary objective of a currency swap is to minimize exposure to risk in the forex market without relying on leverage or other financial instruments. It is a low-risk, cost-effective strategy for minimizing market risk exposure without relying on financial instruments, leading to lower charges.
- It is possible to lower the forex margins: A currency swap can be utilized as an interest rate spread to decrease the forex margin. A wide interest rate spread signifies a high Net Return on Investment (ROI), contributing to the reduction of FX margins.
- It makes it possible to increase ROI: A currency swap enables the enhancement of ROI by minimizing forex exposure. This, in turn, frees up capital that can be utilized for other investments instead of being tied up in the FX market.
- It can be used instead of a forward contract: Usually, forex exposure can be limited using a forward contract. However, there are instances when a currency swap becomes more effective in limiting exposure to the FX market.
- It can aid with debt counseling: Debt management involves tracking financial assets and liabilities to achieve financial goals. A currency swap can assist in more effectively managing debt.
- Reduces exposure to foreign currency: Another method to obtain cash flows in foreign currencies is to borrow in the local currency and exchange the cash flows at the spot rate. The risk of this approach lies in its dependence on the spot rate. If the spot rate changes negatively, the borrower may pay significantly more than if they had initially taken the loan at the higher international rate.
Risk of Cross Currency Swap
Currency swaps carry a risk of loss, yet many investors will continue to use this instrument to maintain their forex exposure. However, the following are some of the hazards connected with currency swaps:
- Purchased to fulfill the contract and prevent cancellation by the counterparty.
- Inability to deliver on the contract may result in a substantial termination charge.
- When arranging a currency swap, it is crucial to understand the complexities of the contract and exercise caution due to numerous factors.
- It is essential to monitor the annual LIBOR rate and various other factors, including exchange rate movements.
- There is a risk of currency depreciation, resulting in financial loss, especially when the inflation rate is high and the currency depreciates rapidly.
- While cross-currency swaps offer attractive benefits, they also introduce new risks. If the counterparty fails to make payments, the party may be unable to repay its debt. This risk is mitigated through cross-currency swaps involving a swap bank, which can thoroughly assess party creditworthiness and their capacity to meet obligations.
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