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What is a 'Cross-Currency Swap'

A cross-currency swap is an over-the-counter derivative in a form of an agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies. In a cross-currency swap, a loan's interest payments and principal in one currency would be exchanged for an equally valued loan and interest payments in a different currency.

BREAKING DOWN 'Cross-Currency Swap'

The reason companies use cross-currency swaps is to take advantage of comparative advantages. For example, if a U.S. company is looking to acquire some yen and a Japanese company is looking to acquire U.S. dollars, these two companies could perform a swap. The Japanese company likely has better access to Japanese debt markets and could get more favorable terms on a yen loan than if the U.S. company went in directly to the Japanese debt market itself, and vice versa in the United States for the Japanese company.

Unlike interest rate swaps, currency swaps involve both the principal and interest of the loan. Both of these are exchanged from one currency to another, and both parties involved mutually benefit.

The Uses of Currency Swaps

Currency swaps can be used in three ways.

First, currency swaps can be used to purchase less expensive debt. This is done by getting the best rate available of any currency and then exchange it back to the desired or needed currency with back-to-back loans.

Second, currency swaps can be used to hedge against foreign exchange rate fluctuations. Doing so helps individual investors and institutions reduce the risk involved in being exposed to volatile foreign exchange markets.

Last, currency swaps can be used by countries as a defense against financial crises. Currency swaps allow countries to have liquid access to income by allowing other countries to borrow their own currency.

Currency Swaps Used to Exchange Loans

Some of the most common structures for exchanging loans with currency swaps include exchanging only the capital, mixing the loan principal with an interest rate swap and swapping the interest payment cash flows alone. Some structures act like a futures contract in which the principal is exchanged with a counter party at a particular point in the future. Much like a futures contract, this structure also provides an agreed rate for the swap. This kind of currency swap is widely known as the FX-swap. Other structures add in an interest rate swap. These structures are also called the back-to-back loans as both of the parties involved are borrowing the other's designated currency.

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