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Currency Swap

A cross currency swap allows two parties to exchange interest payments and principal amounts in different currencies. This allows each party to borrow in their currency of advantage while still obtaining exposure to the other currency. The main benefits are gaining from comparative interest rate differences and eliminating foreign currency exposure risks.

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johny Saha
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37 views

Currency Swap

A cross currency swap allows two parties to exchange interest payments and principal amounts in different currencies. This allows each party to borrow in their currency of advantage while still obtaining exposure to the other currency. The main benefits are gaining from comparative interest rate differences and eliminating foreign currency exposure risks.

Uploaded by

johny Saha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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What is Cross Currency Swap?

Cross currency swap refers to an agreement between two parties to trade currencies.
Over the duration of the swap, the interest payments are exchanged periodically, with
the equal value principal exchanged at the origin and maturity.

How Does Cross Currency Swap Work?

Cross currency swap is based on comparative advantages of borrowing. Borrowers can


get the lowest cost of borrowing on their domestic currency but will be faced with a
higher cost for borrowing foreign currencies. Therefore, cross currency swap works by
finding a counterparty from a foreign country that can borrow at their domestic
advantageous rate. At the same time, the party borrows at their domestic rate, and
immediately the two parties swap debt obligations.

In this example, Party A enjoys a comparative advantage over Party B in borrowing C$,
but Party A wants to borrow $. On the other hand, Party B has an advantage over Party
A in borrowing $, but they want to borrow C$. If they enter a cross currency swap, both
parties can enjoy more favorable rates.

Quality Spread Differential


A way to calculate the potential gain from trade is by determining the quality spread
differential (QSD).

QSD = $(7% – 6%) – C$(9% – 10%) = 2%

Through a cross currency swap, the two parties can enjoy a combined 2% gain from
trade.
The principal (of equal amount) is swapped at year 0, and interest payments are paid by
the counterparty over the term. At maturity, both the principal and interest on the foreign
currency are repaid by the counterparty, which ends the swap obligation. The after-
swap cash flow is the same as if the parties could borrow at the domestic rate of the
foreign currency.

Party A borrows at 9% C$ and swaps the debt with Party B, who borrows at 6% $. Each
party saves 1% compared to if they had borrowed at their available foreign rate. Party
B’s cash flows are the exact opposite of Party A’s.

Swap Bank
Realistically, it is very hard to personally find a counterparty that needs the same
amount and maturity in the foreign market. Therefore, an intermediary swap bank is
usually present – they help find a counterparty to fit your needs, facilitate the exchange
of cash flows and take on some risk. In exchange, swap banks take a fee for their
services. This fee must be smaller than the quality spread differential; otherwise, there
would be no incentive for the parties to enter the swap.
Benefits of Cross Currency Swap

Gain From Trade (QSD)


The most obvious benefit of a cross currency swap is being able to borrow at a lower
rate than from the available foreign rate.

Eliminates Foreign Currency Exposure


An alternative method of receiving foreign currency cash flows is by borrowing at the
domestic currency and exchanging the cash flows at the spot rate (current exchange
rate). The risk from using such a method is the dependency on the spot rate. If the spot
rate fluctuates unfavorably, the party can end up paying a lot more than if they originally
borrowed at the higher available foreign rate. With a cross currency swap, parties can
cement the exchange rate at origin, so the cash flows are known.

Risk of Cross Currency Swap

Counterparty Default Risk

While cross currency swaps present compelling benefits, it also creates a new risk. If
the counterparty to the swap fails to meet their payments, the party cannot pay their
loan. Such a risk is mitigated through cross currency swaps with a swap bank
present, which can thoroughly assess party creditworthiness and their ability to
meet their obligations.
An FX swap agreement is a contract in which one party borrows one currency from, and
simultaneously lends another to, the second party. Each party uses the repayment obligation to its
counterparty as collateral and the amount of repayment is fixed at the FX forward rate as of the
start of the contract. Thus, FX swaps can be viewed as FX risk-free collateralised
borrowing/lending. The chart below illustrates the fund flows involved in a euro/US dollar swap
as an example. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B,
where S is the FX spot rate. When the contract expires, A returns X·F USD to B, and B returns X
EUR to A, where F is the FX forward rate as of the start.

FX swaps have been employed to raise foreign currencies, both for financial institutions and
their customers, including exporters and importers, as well as institutional investors who wish to
hedge their positions. They are also frequently used for speculative trading, typically by
combining two offsetting positions with different original maturities. FX swaps are most liquid at
terms shorter than one year, but transactions with longer maturities have been increasing in
recent years. For comprehensive data on recent developments in turnover and outstanding in FX
swaps and crosscurrency swaps, see BIS (2007).

A cross-currency basis swap agreement is a contract in which one party borrows one currency
from another party and simultaneously lends the same value, at current spot rates, of a second
currency to that party. The parties involved in basis swaps tend to be financial institutions, either
acting on their own or as agents for non-financial corporations. The chart below illustrates the
flow of funds involved in a euro/US dollar swap. At the start of the contract, A borrows X·S
USD from, and lends X EUR to, B. During the contract term, A receives EUR 3M Libor+ α
from, and pays USD 3M Libor to, B every three months, where α is the price of the basis swap,
agreed upon by the counterparties at the start of the contract. When the contract expires, A
returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the
start of the contract. Though the structure of cross-currency basis swaps differs from FX swaps,
the former basically serve the same economic purpose as the latter, except for the exchange of
floating rates during the contract term.

Cross-currency basis swaps have been employed to fund foreign currency investments, both by
financial institutions and their customers, including multinational corporations engaged in
foreign direct investment. They have also been used as a tool for converting currencies of
liabilities, particularly by issuers of bonds denominated in foreign currencies. Mirroring the tenor
of the transactions they are meant to fund, most cross-currency basis swaps are long-term,
generally ranging between one and 30 years in maturity.

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