What is a Cross-Currency Swap
Cross-currency swaps are an over-the-counter 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 equally valued principal and interest payments in a different currency. Interest payments are exchanged at fixed intervals during the life of the agreement.
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.
Breaking Down the Cross-Currency Swap
A cross-currency swaps is used 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. The interest rates on a swap can be fixed, floating, or both.
Exchange of Principal
If the two parties exchange principal for the life of the agreement, there is exchange rate risk involved. 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. The exchange rate in the market could be drastically different in 10 years. The company that ends up with the currency that has appreciated is better off. That said, companies typically use these products to hedge or lock in rates or amounts of money, not speculate.
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 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 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 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 an 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.