What is a Cross-Currency Swap?
Cross-currency swaps are an over-the-counter (OTC) derivative in a form of an agreement between two parties to exchange interest payments and principal denominated in two different currencies. In a cross-currency swap, interest payments and principal in one currency are exchanged for principal and interest payments in a different currency. Interest payments are exchanged at fixed intervals during the life of the agreement. Cross-currency swaps are highly customizable and can include variable, fixed interest rates, or both.
Since the two parties are swapping amounts of money, the cross-currency swap is not required to be shown on a company's balance sheet.
Exchange of Principal
In cross-currency, the exchange used at the beginning of the agreement is also typically used to exchange the currencies back at the end of the agreement. For example, if a swap sees company A give company B £10 million in exchange for $13.4 million, this implies a GBP/USD exchange rate of 1.34. If the agreement is for 10 years, at the end of the 10 years these companies will exchange the same amounts back to each other, usually at the same exchange rate. The exchange rate in the market could be drastically different in 10 years, which could result in opportunity costs or gains. That said, companies typically use these products to hedge or lock in rates or amounts of money, not speculate.
The companies may also agree to mark-to-market the notional amounts of the loan. This means that as the exchange rate fluctuates small amounts of money are transferred between the parties to compensate. This keeps the loan values the same on a marked-to-market basis.
Exchange of Interest
A cross-currency swap can involve both parties paying a fixed rate, both parties paying a floating rate, one party paying a floating rate while the other pays a fixed rate. Since these products are over-the-counter, they can be structured in any way the two parties want. Interest payments are typically calculated quarterly.
The interest payments are usually settled in cash, and not netted out, since each payment will be in a different currency. Therefore, on payment dates, each company pays the amount it owes in the currency they owe it in.
The Uses of Currency Swaps
Currency swaps are mainly 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 exchanging it back to the desired currency with back-to-back loans.
Second, currency swaps can be used to hedge against foreign exchange rate fluctuations. Doing so helps institutions reduce the risk of being exposed to large moves in currency prices which could dramatically affect profits/costs on the parts of their business exposed to foreign markets.
Last, currency swaps can be used by countries as a defense against a financial crisis. Currency swaps allow countries to have access to income by allowing other countries to borrow their own currency.
- Cross-currency swaps are used to lock in exchange rates for set periods of time.
- Interest rates can be fixed, variable, or a mix of both.
- These instruments trade OTC, and can thus be customized by the parties involved.
- While the exchange rate is locked in, there is still opportunity costs/gains as the exchange rate will likely change. This could result in the locked-in rate looking quite poor (or fantastic) after the transaction occurs.
- Cross-currency swaps are not typically used to speculate, but rather to lock in an exchange rate on a set amount of currency with a benchmarked (or fixed) interest rate.
Example of a Currency Swap
One of the most commonly used currency swaps is when companies in two different countries exchange loan amounts. They both receive the loan they want, in the currency they want, but on better terms than they could get by trying to get a loan in a foreign country on their own.
For example, a US company, General Electric, is looking to acquire Japanese yen and a Japanese company, Hitachi, is looking to acquire U.S. dollars (USD), 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.
Assume General Electric needs ¥100 million. The Japanese company needs $1.1 million. If they agree to exchange this amount, that implies a USD/JPY exchange rate of 90.9.
General Electric will pay 1% on the ¥100 million loan, and the rate will be floating. This means if interest rates rise or fall, so will their interest payments.
Hitachi agrees to pay 3.5% on their $1.1 million loan. This rate will also be floating. The parties could also agree to keep the interest rates fixed if they so desire.
They agree to use the 3-month LIBOR rates as their interest rate benchmarks. Interest payments will be made quarterly. The notional amounts will be repaid in 10 years at the same exchange rate they locked the currency-swap in at.
The difference in interest rates is due to the economic conditions in each country. In this example, at the time the cross-currency swap is instituted the interest rates in Japan are about 2.5% lower than in the U.S..
On the trade date, the two companies will exchange or swap the notional loan amounts.
Over the next 10 years, each party will pay the other interest. For example, General Electric will pay 1% on ¥100 million quarterly, assuming interest rates stay the same. That equates equate to ¥1 million per year or ¥250,000 per quarter.
At the end of the agreement, they will swap back the currencies at the same exchange rate. They are not exposed to exchange rate risk, but they do face opportunity costs or gains. For example, if the USD/JPY exchange rate increases to 100 shortly after the two companies lock into the cross-currency swap. The USD has increased in value, while the yen has decreased in value. Had General Electric waited a bit longer, they could have secured the ¥100 million while only exchanging $1.0 million instead of $1.1 million. That said, companies don't typically use these agreements to speculate, they use them to lock in exchange rates for set periods of time.