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
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
posted by Pankaj Ratna at 10:58 AM
0 Comments:
Post a Comment
<< Home