Understanding Cross-Currency Swaps

It's a linear interest rate derivative and one of the most liquid as it can span many currencies at the same time. These swaps can benefit corporations by getting into an agreement while the currency's interest rate is quite low, especially during a financial crisis. Governments have also used these swaps to support financial stability.

The applications for cross-currency swaps span industries and countries. Let's talk about the implications of entering into this kind of agreement.

What Is a Cross-Currency Swap?

Currency swaps are a kind of over-the-counter (OTC) product within the foreign exchange market. Investors can exchange differing currencies on a Forex trading platform. Since the trade doesn't happen on a centralised exchange, it can be customised at any point in the agreement. That means traders can reverse a previously fixed or specified date and delay payments or change the amounts of each currency depending on the country's economic conditions.

A cross-currency swap between two parties occurs when they agree to exchange principal and interest payments denominated in a different currency. At its core, it's an interest rate derivative (IRD) which means its market value is based on the interest-bearing assets.

Interest rates can be variable, fixed, or both, making the agreement highly customisable. These exchanges are set at fixed intervals for the length of the agreement. A cross-currency swap can be used to take advantage of a low exchange rate on a set amount and is not required to be reflected on the company's balance sheet.

How Does a Cross-Currency Swap Work?

Let's look at a cross-currency swap example between American and Japanese counterparties whose corresponding forex pair is USD/JPY.

Assume that the Japanese party hopes to borrow $100 million and can lend ¥50 million to the American counterparty. The JPY exchange rate for this contract is, therefore, $2 per JPY and is indexed to the London Interbank Offered Rate (LIBOR).

The American party will pay all interest payments on a quarterly basis in JPY to the Japanese party plus a basis swap price. The Japanese party will, in turn, pay their American counterparty in USD at the LIBOR interest rate. Both parties can agree to keep a fixed interest rate or allow them to change based on the economic state of the home countries.

At the end of the contract, the full Japanese debt of $100 million will be paid back to the American counterparty, and they receive the full ¥50 million in exchange.

Cross-Currency Swaps and Hedging

Although a cross-currency swap agreement is not a hedge in itself, it can be used as a currency hedging strategy in the forex market. Most companies that trade on an international scale may experience some level of currency risk, especially if the exchange rates change before the foreign currency gets converted to the desired currency.

In a volatile political or economic period, a currency's exchange rates can fluctuate greatly and even reduce its value. Entering a cross-currency swap at this time can be a strong move.

Dual Currency Swap and Interest Rate Swap

Two parties enter a swap, which are derivative agreements involving the exchange of cash flows. That's where the similarities between an interest rate and cross-currency swap end. While cross-currency swaps are a foreign exchange contract, the exchanged cash flow streams from one currency into the other. Interest rate swaps only work with one currency, and the cash flow comes from two different interest rates.

Types of Cross-Currency Swaps

There are two main kinds of foreign currency swaps:

• Fixed-for-fixed currency swap: the parties involved exchange currencies with each other at a fixed interest rate, specifically on the principal amount. This is a great option to take advantage of situations where interest rates on another currency are cheaper.
• Fixed-for-floating swaps: one of the parties exchanges the interest cash flows (not principal) of a fixed-rate loan with a floating-rate loan of the other party. The swap will reduce the interest expense if the floating rate is lower than the current fixed rate.

Benefits and Risks of Cross-Currency Swaps

How Do FX Swaps Differ From Cross-Currency Swaps?

FX Swaps, FX forward, and cross-currency trades have some similarities but also glaring differences that allow each technique to be useful in various financial situations.

Let's start with a cross-currency basis swap. These are currency derivatives that are mainly focused on interest payments. Forex or FX swaps don't exchange interest between the two parties, and the amount of principal exchanged at the start and end of the agreement is usually a different value.

Cross-currency swaps usually have a long agreement, sometimes paid for over decades. FX swaps can be traded for as short as a day, which makes them a great option for short-term investing. The general disadvantage of FX swaps is they cannot be used to counter interest-rate risks.

A dual currencyswap agreement is similar to a forward contract since the latter is also a type of derivative product. It's an agreement or contract between a buyer and seller for a future trade at a specific price.

However, it doesn't deal with interest rate risk like cross-currency swaps. FX forwards can also only be used to hedge the principal repayment of a loan and the risk of changing foreign exchange rates. This means it doesn't cover all aspects of currency risk, making cross-currency more attractive to investors.

What Are Cross-Currency Swaps Used For?

Purchasing Less Expensive Debt

A company can get a currency with the best current rate available and exchange it back to the desired currency with a parallel or back-to-back loan.

Hedging Against Foreign Exchange Rate Fluctuations

Institutions can avoid being exposed to large currency price fluctuations that usually affect the profits/costs of the businesses that are exposed to foreign markets.

Defending Against a Financial Crisis

Cross-currency swaps can provide countries with a new income stream by allowing other countries to borrow their currency. The method can be especially helpful when the country is in a state of liquidity crisis and needs a loan that can be paid back in interest payments until its economy becomes stabler.

How Are Cross-Currency Swaps Valued?

Cross-currency swaps can be difficult to value. Traditional trading rules assume that a currency's funding cost and floating rate are equal. That would give a zero cross-currency spread. However, each currency has a different funding cost since investors have differing levels of access to these various international currencies.

Investors have found a way around this by selecting one currency to be the funding currency and choosing a curve in this currency as the discount curve. Future earnings are discounted according to the current market interest rates.

The total foreign currency cash flows are then swapped into the funding currency at its spot price before it gets discounted. Cross-currency swaps are unique when compared to other interest-rate derivatives as they always have an exchange of face value or a notional amount.

Conclusion

Cross-currency basis swaps are useful to effectively hedge currency risk within the forex market. They may not be the best option for a short-term or professional day trader who generally prefers the simpler FX swap, but they have their place. Large corporations and institutional investors who frequently trade foreign currency at the international level may be interested in the method.

As with any new financial method, cross-currency swaps come with risks. However, forex traders interested in practising the technique without jeopardising their fortunes can do so on Libertex. After creating an account there, you can start practising trading on the platform.

Demo trading on Libertex mimics live trading conditions. The main difference is you can use virtual credits instead of depositing your own funds. The account doesn't expire, allowing you to use it anytime you need it. It's a great tool to learn new trading skills before applying them on a real account.