Cross-Currency Swap

What is a Cross-Currency Swap?

A cross-currency swap is a derivative contract that financial institutions and multinational companies typically use to hedge their currency and interest rate exposures, access foreign capital markets or align the currencies in which their assets and liabilities are denominated. It essentially involves two parties exchanging principal and interest payments in different currencies over a specified period. While foreign currency (FX) swaps usually require a spot and forward exchange, cross-currency swaps involve a simultaneous exchange at the beginning, periodic interest payments in each currency (which can be fixed-for-fixed, fixed-for-floating or floating-for-floating) and then re-exchange at maturity. This enables investors to borrow in one currency, swap the cash flows into another and lock in both their exchange rate and interest rate exposure. There are two components to the pricing of a cross-currency swap: interest rate differentials and forward currency rates.

How Do Cross-Currency Swaps Work?

The process of how cross-currency swaps work can be divided into different stages. We outline them below.

1.      Agreement and setting up the contract

At this initial stage, the two parties agree on the terms of the contract such as:

• The notional amounts in each currency
• The type of interest, which can be fixed or floating
• The reference rates – for example SOFR (the Secured Overnight Financing Rate) or EURIBOR (the Euro Interbank Offered Rate)
• How frequently the payments will be made (monthly, quarterly, semi-annually etc.)
• The swap tenor (for example one, three, five or ten years)
• What exchange rate will be used for principal exchanges

Then, the parties establish a legal agreement using an ISDA Master Agreement, a standardized contract published by the International Swaps and Derivatives Association (which governs the over-the-counter derivatives transactions). The margining and collateral procedures to reduce counterparty risk are usually also outlined by a Credit Support Annex (CSA).

2.      The initial exchange of notional

This is the inception stage. On the effective date, the two parties exchange the agreed notional principal amounts in their respective currencies (typically using the spot FX rate). The full amounts are transferred, and this will be used as a base to calculate future interest payments.

3.      Periodic interest payments

During the life of the contract, each party has the obligation to pay interest on the notional amount received. These payments are made in each party’s local currency and can be structured as:

• “Fixed vs. Fixed”, where both parties pay fixed interest (for example, 2.5% USD versus 1.5% EUR)
• “Fixed vs. Floating” – one side pays fixed and the other floating (for example,e 3% GBP versus EURIBOR + 50 basis points)
• “Floating vs. Floating”, in which both sides make floating payments (reference rates can vary)

Payments are calculated using actual/360 (or actual/365) day-count conventions depending on the currency.

4.      Final re-exchange

On the agreed maturity date, the two parties re-exchange the original notional amounts. This is typically done and ensures that both parties fully return to their original currency position. This eliminates principal currency risk, and no gains or losses should occur on the principal.

However, there are also alternative approaches in which the two parties may agree to re-exchange notional amounts at a pre-agreed forward rate. This would happen in cases where one of the sides may be speculating on currency movements or if the swap is customized for specific hedging needs.

While the process is relatively straightforward, there could, however, be some complications arising from early termination of the contract. Should one of the parties wish to terminate the swap early (this may occur for various reasons such as changing funding needs), a mark-to-market (MTM) valuation is required. This would reflect the present value of the remaining cash flows based on current interest rates and currency rates. Any market value changes need to be compensated by a settlement. Finally, the collateral may be transferred or returned according to terms set in the CSA.

How to Price a Cross-Currency Swap?

The pricing of cross-currency swaps is not as straightforward as that of a standard interest rate swap since it requires the valuation of cash flows in two different currencies, adjusting for exchange rates, interest rate curves and basis spreads. They typically involve the use of sophisticated tools such as the Bloomberg Terminal or Thomson Reuters to obtain live FX and interest rate data as well as discount factor curves and ISDA’s model documentation (used for valuation conventions). The following summarizes the process.

How Are Cross-Currency Swaps Used?

Cross-currency swaps can be used in many areas, such as managing currency and interest rate risk, facilitating cross-border or optimizing capital structure. They enable institutions or companies to obtain foreign currency funding while at the same time converting the exposure into their domestic currency. For example, a European company issuing debt in Japanese Yen to access cheaper capital can use a cross-currency swap to exchange the Yen principal and interest payments into Euros. This would essentially align cash flows with the company’s functional currency.

Another application that cross-currency swaps find is managing the asset-liability currency profile of financial institutions. They reduce foreign exchange risk by ensuring that liabilities and income streams are denominated in the same currency.

In addition, cross-currency swaps are often used in capital markets by sovereign entities (governments) to access international funding. Central banks may also use them to provide liquidity in foreign currency during periods of market stress. Multinational companies would use them to hedge long-term investments or future cash flows in foreign currencies, while in the interbank market, they can also be used for arbitrage opportunities (based on basis spreads between currency pairs).

The below chart shows that cross-currency swaps form a relatively small part of the overall global foreign exchange markets as measured by turnover.

Advantages and Disadvantages of Cross-Currency Swaps

While there are some clear advantages of the cross-currency swaps (which we have already discussed and are summarized below), there are also some disadvantages are risks that investors should consider.

Advantages

• They offer protection against fluctuations in exchange rates and interest rates over the life of the contract
• Cross-currency swaps also enable companies to tap into foreign capital markets with more favourable rates and then convert proceeds into their desired currency
• The high flexibility in their terms allows the counterparties to tailor the swap to match the timing and structure of cash flows or debt obligations

Disadvantages

• Exposure to the risk that the other party may default, especially over long durations (counterparty risk)
• Cross-currency swaps require complex and resource-demanding legal structuring (for example, the ISDA agreements that we mentioned above), pricing models and active management
• Mark-to-market (MTM) valuations can be highly volatile with interest rate or foreign currency movements

Example of a Cross-Currency Swap

In this download, we provide a practical example of a cross-currency swap that two multinational companies use.

Conclusion

Overall, cross-currency swaps are a key tool for managing currency risk, optimizing funding costs, and facilitating foreign funding access. The exchange of principal and interest payments in different currencies allows the different parties to hedge their exposure to foreign exchange fluctuations and benefit from favourable interest rate differentials.  However, they also carry inherent risks, including counterparty, interest rate, and possibly liquidity risks.

Additional Resources

Interest Rate Swap

Exchange Rates

Foreign Exchange Markets