A cross-currency swap is an agreement between two parties to exchange interest payments and principal in two currencies. The primary purpose of a cross-currency basis swap is to access lower borrowing costs. A cross-currency swap is a derivative contract traded over the counter (OTC), and both parties can customize it to their liking. Since two parties swap capital, neither one must report it on their balance sheet, as the principal amount is identical.
Interest payments occur during fixed periods outlined in the contract, and the exchange rate is locked in. Since the Forex market fluctuates 24/5, the outcome could either be more beneficial or worse, dependent on market conditions. Speculators usually do not engage in cross-currency swaps, as they serve to lock in or hedge exchange rates and take advantage of interest rate differentials.
What is a Cross-Currency Swap?
Two parties seeking to borrow an identical sum in the Forex market can engage in a cross-currency swap if both parties have access to more favorable interest rates which the other party seeks. For example, Party A has cheaper US Dollar interest rates but seeks Euros, and Party B has beneficial Euro interest rates but seeks US Dollars. A cross-currency swap allows both parties to lower borrowing costs.
Since it is challenging for an individual or a company to locate a counterparty in the $7 trillion+ Forex markets seeking to borrow the same amount in a different currency, an intermediary, usually a bank, often referred to as a swap bank, assists with the transaction. It facilitates the cross-currency swap, takes on risk, and charges a fee for its services. Cross-currency swap parties must ensure that the bank costs are below the cost savings achieved from the interest rate differential.
Why Use a Cross-Currency Swap?
Two parties enter a cross-currency swap primarily to lower borrowing costs and reduce Forex risk, as the OTC contract locks in both variables for its duration. It creates stability for both parties in an off-balance sheet transaction. The cross-deal FX transaction is ideal for parties with multi-national operations as it lowers volatility and offers pricing consistency, which can help during earnings season, a tactic often used by publicly listed companies.
A Cross-Currency Swap Example
The blow cross-currency example is a simple illustration to help explain the cross deal meaning and why two parties enter a cross-currency swap.
Assume the following:
- Party A, a New Zealand-based company, wants to borrow $10,000,000
- Party B, a US-based company, wants to borrow N$16,200,000
- The exchange rate is 0.61728
- The contract duration is five years
- Party A can borrow NZD at 2.00% and USD at 4.00%
- Party B can borrow USD at 3.50% and NZD at 2.50%
- Both parties agree on quarterly, fixed interest rate payments
Therefore:
- Party A borrows NZ$16,200,000 at 2.00% and sends it to Party B
- Party B borrows $10,000,000 at 3.50% and sends it to Party A
- Both parties complete a cross-currency swap
- Both parties get access to cheaper borrowing costs, 0.50% lower for each
- Both parties lock in the exchange rate at 0.61728
- Every three months, both parties swap interest rate payments
- At the end of the contract, both parties swap the principal at 0.61728, irrelevant of the actual exchange rate, which could be above or below the agreed rate
How to Calculate a Cross-Currency Swap Benefit
Calculating the cross-currency swap valuation is essential to understanding the potential benefit.
The below formula remains widely used to calculate a cross-currency swap benefit:
Quality Spread Differential (QSD) = [Currency1 (Party A - Party B)] - [Currency2 (Party A - Party B)]
Assume the following:
USD Interest Rate (Currency 1) | NZD Interest Rate (Currency 2) | |
|---|---|---|
Party A (NZ, NZD) | 4.00% | 2.00% |
Party B (US, USD) | 3.50% | 2.50% |
Therefore, the cross-currency swap benefit is:
[USD (4.00% - 3.50%)] - [NZD (2.00% - 2.50%] = 1.00%
The Opportunities and Risks of a Cross-Currency Swap
Before entering a cross-currency swap, two parties must evaluate and understand the opportunities and risks involved.
The opportunities of a cross-currency swap:
- Lower borrowing costs, as parties access lower interest rates and lock them in for the contract duration
- Hedge against Forex volatility, as both parties agree on an exchange rate and swap principal at the end at the same rate
- Pricing stability, due to locked-in interest and exchange rates
- Off-balance sheet transactions, assisting financial departments during earnings reporting season
The risks of a cross-currency swap:
- Counterparty default risk, which parties can decrease by using a swap bank that conducts due diligence, including a creditworthiness assessment
- Opportunity costs and risks increase, but parties using a cross-currency swap use it to lock in exchange and interest rates and not to speculate
Cross Deal Conclusion
A cross-currency swap or cross deal can help two parties lower borrowing costs, hedge against Forex volatility, and achieve pricing stability in an off-balance sheet transaction. Using an intermediary bank, sometimes referred to as a swap bank, will eliminate most risks involved in an OTC cross-currency swap. Both parties miss out on potential opportunity gains as they lock in interest and exchange rates, but cross-currency swaps are not for speculators.
FAQs
What is the difference between a currency swap and a cross-currency swap?
A currency swap, or FX swap, involves two transactions, buying/selling at the spot rate and selling/buying at the forward rate, using available capital. A cross-currency swap involves both parties taking a loan, paying interest rates, and exchanging payments at fixed intervals for the contract duration.
How does currency swap between countries work?
Two central banks enter into a currency swap line agreement, exchanging an identical amount of their currencies. For example, the Bank of Japan and the National Bank of India can agree to swap the Japanese Yen and the Indian Rupee to fulfill their domestic Forex requirements.
How many cross-currency pairs are there?
The Forex market consists of hundreds of cross-currency pairs, but not all are suitable for a cross-currency swap, which depends on significant interest rate differentials.