Cross Currency Swap

CROSS CURRENCY SWAP
DESCRIPTION
Similar to an Interest Rate Swap but where each leg of the swap is denominated in a different currency. A Cross Currency Swap therefore has two principal amounts, one for each currency. Normally, the exchange rate used to determine the two principals is the then prevailing spot rate although for delayed start transactions, the parties can either agree to use the forward FX rate or agree to set the rate two business days prior to the start of the deal. With an Interest Rate Swap there is no exchange of principal at either the start or end of the transaction as both principal amounts are the same and therefore net out. For a Cross Currency Swap it is essential that the parties agree to exchange principal amounts at maturity. The exchange of principal at the start is optional (see Corporate example below).
Like all Swaps, a Cross Currency Swap can be replicated using on-balance-sheet instruments, in this case loan and deposits in different currencies. This explains the necessity for principal exchanges at maturity as all loans and deposits also require repayment at maturity. While the corporate or investor counterparty can elect not to exchange principal at the start, the bank needs to. This initial exchange can be replicated by the bank by entering into a spot exchange transaction at the same rate quoted in the Cross Currency Swap.
Loosely speaking, all foreign exchange forwards can be described as Cross Currency Swaps as they are agreements to exchange two streams of cashflows (in this case a stream of one!) in different currencies. Many banks manage Long Term Foreign Exchange Forwards as part of the Cross Currency Swap business given the similarities. Like all FX Forwards, the Cross Currency Swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency, and the swap leg they have agreed to receive, is an asset in the other currency.
One of the major market users for Cross Currency Swaps are Debt issuers, particularly in the Euro-markets where issuers sell bonds in the "cheapest" currency and swap their exposure to their desired currency (see Pricing).
A Cross Currency Swap where both legs are floating rate is part of the Basis Swap product family. Cross Currency Swaps are also known as a CIRCA (a Currency and Interest Rate Conversion Agreement).
EXAMPLE
Investor
A fund manager is seeking to purchase 3 yr DEM assets with a minimum credit rating of AA and a yield in excess of LIBOR plus 12. A review of the DEM Floating Rate Note market and even the DEM fixed rate bond market swapped into floating rate using an Asset Swap, shows that no such assets exist in reasonable volume. A 3 yr GBP AA rated Corporate bond can be purchased at a yield of GBP LIBOR plus 18bp for a total price of GBP 10,000,000. The prevailing exchange rate is 2.50. The fund manager can purchase the bond for GBP10,000,000 and simultaneously enter into a Cross Currency Swap agreeing to pay GBP LIBOR plus 18bp and receive DEM LIBOR plus 15bp (see Pricing for an explanation of the price differential). The spot rate is set at 2.50 and the fund manager elects to exchange principal at the start.
The initial cashflows are as follows:

Investor buys bond:
-GBP 10,000,000
Cross Currency Swap:
+GBP 10,000,000

-DEM 25,000,000

The swap agreement nets out the initial GBP flow and replaces it with an equivalent DEM flow. Over the life of the bond, the fund manager pays the GBP coupons (LIBOR plus 18bp) to the bank counterparty and receives DEM LIBOR plus 15bp. At maturity, the following flows occur irrespective of the prevailing exchange rate:

Bond Redeems to Investor:
+GBP 10,000,000
Cross Currency Swap:
-GBP 10,000,000

-DEM 25,000,000

Again, the GBP bond flows are cancelled out by the swap flows leaving a DEM redemption to the investor. By using the Cross Currency Swap the fund manager has created a synthetic DEM Floating Rate Asset.
The fund manager does not wear any currency exposure as the currency exposure created by the swap (i.e. de asset, GBP liability) is offset by the currency exposure created by the purchase of the GBP bonds (i.e. GBP asset), leaving a net position only in the base currency of DEM. Of course, the investor bears the full credit risk of the underlying bond and should the bond default, the investor is still obliged to make all remaining payments under the swap or reverse the swap at its then book value.
Issuer
A New Zealand company is looking to raise NZD 100 million by issuing 10 year bonds. In the New Zealand domestic market, it would issue at a yield of LIBOR plus 25bp. Alternatively it can issue in Australia where there is a shortage of quality bonds, at a yield of 7.50%. It can then enter into a 10 year Cross Currency Swap for a notional amount of NZD 100 million agreeing to receive AUD 7.50% and pay NZD LIBOR plus 20bp (see Pricing). The prevailing spot rate is 1NZD = 0.90AUD. The initial cashflows are as follows:
Company issues bond:
+AUD 90,000,000
Cross Currency Swap:
-AUD 90,000,000

+NZD 100,000,000
The swap agreement nets out the initial AUD flow and replaces it with an equivalent NZD flow which the company can use to fund its operations as planned. Over the life of the bond, the company receives the AUD coupons from the bank counterparty that it owes to the bond investors, and pays instead NZD LIBOR plus 20bp.
At maturity, the company will receive the AUD bond principal amount it owes the Bond investors from the swap counterparty, and in return is required to pay NZD 100 million irrespective of the then spot rate. Using the Cross Currency Swap, the company has created a synthetic NZD liability.
Corporate
A multinational company uses USD as its base currency. The company has assets denominated in many different currencies, but the Board or Directors is particularly concerned about the assets denominated in Spanish Peseta, which represent over 20% of the company. While the assets are intended to be held for the long term the Board is concerned that any fluctuations in the spot rate will lead to an increase in the volatility of earnings. In total, there are ESP 120bn Spanish assets with no corresponding ESP liabilities. The majority of company liabilities are denominated in USD. The currency exchange rate is 1USD = 120ESP. The company has considered raising ESP debt in the Spanish market and repaying USD debt as a way to hedge this exposure, however the company is not well known in Spain and would need to pay LIBOR plus 45bp in order to do so. Alternatively, the company can enter into a Cross Currency Swap as follows:
ESP Principal:
ESP 120 billion
USD Principal:
USD 1 billion
Tenor:
10 years (to match the long term nature of the assets)
Company pays:
ESP LIBOR plus 5 bp
Company receives:
USD LIBOR
In this situation, the company would like to create a synthetic ESP liability to offset the ESP assets it owns. There is no new requirement to generate cash and so the company elects not to exchange principal at the start of the deal, so there are no initial cashflows. In effect, the company has transferred some of its USD liabilities into ESP liabilities to offset the ESP assets it owns and thereby reduce its currency exposure. From this point on, any currency loss on the assets will be offset by a corresponding currency gain on the Cross Currency Swap. In this example, the Cross Currency Swap has been used as an effective Foreign Exchange hedge much like the use of an FX forward contract.
PRICING
The pricing in a Cross Currency Swap reflect that level where the market is indifferent to receiving the cashflows on either leg (see Pricing section in Interest Rate Swap). Each leg of the swap can be considered on its own. At the inception of the swap, the present value of one leg (which is calculated using the prevailing zero coupon yield curve for that currency) must be equal to the present value of the other leg at the then prevailing spot rate. Using this simple logic, it would seem natural that a stream of LIBOR flat payments in one currency could be exchanged for a stream of LIBOR flat payments in another currency. This is not always true and the reason is generally a simple case of supply and demand. Where there is excessive demand for Cross Currency Swaps between two particular currencies (or FX Forwards for that matter), the price will tend to rise, and vice versa. This may or may not be to the advantage of the swap user. In general, the price difference is limited to plus or minus 10bp.
Like FX forwards, three things influence the price and value of a Cross Currency Swap:
(a) The yield on currency one(b) The yield in currency two(c) The spot exchange rate
TARGET MARKET
There are three clear target markets:
(a) Investors who wish to purchase foreign assets but seek to eliminate foreign currency exposure(b) Debt issuers who can achieve more favourable rates by issuing debt in foreign currency(c) Liability managers seeking to create synthetic foreign currency liabilities
ADVANTAGES
Off Balance Sheet
Can be cheaper than the cash markets (i.e. issuing foreign currency bonds directly)
Can elect to exchange principal at the start if desired
Simple documentation compared to cash markets (i.e. issuing a bond, arranging a loan)
Can be customised
Can be reversed at any time (albeit at a cost or benefit)
DISADVANTAGES
Unlimited loss potential
PRODUCT SUITABILITY
Simple Defensive/Simple Aggressive

Currency Swap - Part 2

A currency swap is a form of swap. It is most easily understood by comparison with an interest rate swap. An interest rate swap is a contract to exchange cash flow streams that might be associated with some fixed income obligations—say swapping the cash flows of a fixed rate loan for those of a floating rate loan. A currency swap is exactly the same thing except, with an interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are in different currencies.
That difference has a practical consequence. With an interest rate swap, cash flows occurring on concurrent dates are netted. With a currency swap, the cash flows are in different currencies, so they can't net. Full principal and interest payments are exchanged without any form of netting.
Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter into a currency swap to exchange the cash flows associated with
a five-year USD 100MM loan at 6-month USD Libor, and
a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.
All cash flows associated with those loans are paid:
initial receipt/payment of loaned principal,
payment/receipt of interest (in the same currency) on that loan,
ultimate return/recovery of the principal at the end of the loan.
Vanilla currency swaps are quoted both for fixed-floating and floating-floating (basis swap) structures. Fixed-floating swaps are quoted with the interest rate payable on the fixed side—just like a vanilla interest rate swap. The rate can either be expressed as an absolute rate or a spread over some government bond rate. The floating rate is always "flat"—no spread is applied. Floating-floating structures are quoted with a spread applied to one of the floating indexes.
Currency swaps can be used to exploit inefficiencies in international debt markets. Suppose a corporation needs an AUD 100MM loan, but US-based lenders are willing to offer more favorable terms on a USD loan. The corporation could take the USD loan and then find a third party willing to swap it into an equivalent AUD loan. In this manner, the firm would obtain its AUD loan but at more favorable terms than it would have obtained with a direct AUD loan. That advantage must, of course, be balanced against the transaction costs, pre-settlement risk and settlement risk associated with the swap. This is illustrated in Exhibit 1.


Swapping a USD Loan Into an AUD LoanExhibit 1


By entering into a swap with a third party, a corporation can convert an USD loan into an AUD loan.
Just as a vanilla interest rate swap is equivalent to a strip of FRA's, a vanilla fixed-floating currency swap is equivalent to a strip of currency forwards.

Currency Swap

A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped.
Currency swaps can be negotiated for a variety of maturities up to at least 10 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract.
Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies "shop" for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.

CURRENCY SWAPS
In a previous article, we laid out a brief overview of the interest rate swaps market: an exchange of cash flows predicated on two different pre-set interest rate indices for a prescribed schedule of payments. Interest rate swaps are in the same currency. Now, we can introduce currency swaps: interest rate swaps in different currencies involving the exchange of principal amounts at inception and at maturity.

THE EXCHANGE OF PRINCIPAL AT INCEPTION AND AT MATURITY
In an interest rate swap, we were concerned exclusively with the exchange of cash flows relating to the interest payments on the designated notional amount. However, there was no exchange of notional at the inception of the contract. The notional amount was the same for both sides of the currency and it was delineated in the same currency. Principal exchange is redundant.
However, in the case of a currency swap, principal exchange is not redundant. The exchange of principal on the notional amounts is done at market rates, often using the same rate for the transfer at inception as is employed at maturity.
For example, consider the US-based company ("Acme Tool & Die") that has raised money by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss Francs to fund their US operations.
[Why issue bonds in Swiss Francs? The only rationale for doing this is because there are investors with Swiss Franc funds who are looking to diversify their portfolios with US credits such as Acme's. They are willing to buy Acme's Eurobonds at a lower yield than Acme can issue bonds in the US. A Eurobond is any bond issued outside of the country in whose currency the bond is denominated.]

Because this issue is funding US-based operations, we know two things straightaway. Acme is going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer to pay its liability for the coupon payments in US dollars every six months.
Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering into a currency swap with the First London Bank.
Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the same dates as the coupon payments are due to Acme's Eurobond investors, pay US dollar coupon payments tied to a pre-set index and re-exchange the US dollar notional into Swiss Francs at maturity.
Acme's US operations generate US dollar cash flows that pay the US-dollar index payments.
Currency swaps are used to hedge or lock-in the value-added of issuing Eurobonds. They are often negotiated as part of the whole issuance package with the main issuing financial institution.
FLEXIBILITY
Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets.
Interest rate swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum.
Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities.
The success of the currency swap market and the success of the Eurobond market are explicitly linked.
EXPOSURE
Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.
Companies have to come up with the funds to deliver the notional at the end of the contract. They are obliged to exchange one currency's notional against the other currency's notional at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain.
This potential exposure is magnified with time. Volatility increases with time. The longer the contract, the more room for the currency to move to one side or other of the agreed upon contracted rate of principal exchange.
This explains why currency swaps tie up greater credit lines than regular interest rate swaps.
PRICING
We price or value currency swaps in the same way that we learned how to price interest rate swaps, using a discounted cash flow analysis having obtained the zero coupon version of the swap curves.
Generally, currency swaps transact at inception with a net present value of zero. Over the life of the instrument, the currency swap can go in-the-money, out-of-the-money or it can stay at-the-money.
CONCLUSION
Currency swaps allow companies to exploit the global capital markets more efficiently. They are an integral arbitrage link between the interest rates of different developed countries.
The future of banking lies in the securitization and diversification of loan portfolios. The global currency swap market will play an integral role in this transformation. Banks will come to resemble credit funds more than anything else, holding diversified portfolios of global credit and global credit equivalents with derivative overlays used to manage the variety of currency and interest rate risk.