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).

A Cross Currency Swap is an agreement between two parties to exchange interest payments denominated in two different currencies for a specified term. One interest payment is typically calculated using a floating rate index such as USD LIBOR. The other interest payment is based upon a fixed rate or another floating rate index denominated in a different currency.

Example 1

The firm has a loan in dollars which was arranged 3 years ago and which is currently on a floating-rate basis. In the 3 years since then, the business has grown and is now exporting into Europe and receiving foreign currency from France. Managing the risk on the foreign exchange is becoming more and more difficult. The firm are also aware of the interest-rate risk on the loan.

The product

A Cross-Currency Interest-Rate Swap can solve both of these problems at once. This swap allows the firm to switch its loan and interest repayments from one currency into another. It also allows the firm to switch the interest rate from floating to fixed or from fixed to floating. This means the firm can switch a floating-rate dollar loan into a fixed- or floating-rate French Franc loan. The firm will pay floating dollar rate on the original loan but through the Cross-Currency Interest Rate Swap it will receive floating LIBOR. The firm must pay a fixed (or floating) rate in French Francs of an equal amount. The product is particularly useful if you have a loan in dollars and you receive a lot of foreign currency from abroad. The firm can then use this foreign currency to repay its loan.

The solution

The firm have borrowed $1 million which the firm will repay over 3 years. The firm decide to do a Cross-Currency Interest-Rate Swap with a bank. The French Franc and dollar exchange rate is 5 Francs to one Dollar. Under the terms of the swap, banks will do a foreign exchange deal that day so that the firm sells to the bank 1 Million Dollars and banks sell to the firm 5 million French Francs. Banks will pay the firm a floating interest rate on the $1 dollars for 3 years. Banks will pay you $1 million in dollars back at the end of the period. In return the bank will pay a fixed (or floating) interest rate on the French Franc loan of 5 million for 3 years. The firm will pay the bank 5 million Francs back at the end of the swap period. In doing this the firm creates a French Franc loan and it can use the French Francs from its exports to pay off the loan. This gets rid of the problem of managing its foreign exchange risk. And if the firm chooses a fixed interest rate on the French Franc loan it can also get rid of any possible interest-rate risk.

The benefits

Cross-Currency Interest-Rate Swaps allows the firm to switch its loan from one currency to another. They also allow it to choose whether it have fixed- or floating-rate interest.

The swap allows the firm to borrow in the currency which will gives it the best terms. The firm can use Cross-Currency Interest-Rate Swaps to switch the loan back into any currency it chooses.

Cross-Currency Interest-Rate Swaps can reduce foreign currency exposures. The firm can use money it receives in foreign currency to pay off its loans when it switches them.

The firm can protect itself against changes in interest rates by creating fixed-rate loans.

Features

Any bank can provide Cross-Currency Interest-Rate Swaps. The firm does not have to use the bank who provided the original loan.

Banks can tailor Cross-Currency Interest-Rate Swaps to meet your needs. Banks provide Cross-Currency Interest-Rate Swaps for loans in all the major currencies. Maturities are generally up to 5 years but can be longer.

Banks can arrange a Cross-Currency Interest-Rate Swap before the loan is received. These are generally known as Forward-Start Cross-Currency Interest-Rate Swaps.

The firm can cancel a Cross-Currency Interest-Rate Swap at any time, but this may be very expensive if interest rates or foreign exchange rates have changed and work against it.

Unlike a single currency swap, a Cross Currency Swap sometimes (but not always) involves an exchange of principal. The initial principal exchange occurs at the beginning of the swap with a re-exchange at maturity. The principal amounts are based on initial spot exchange rates.

In a Currency Swap, interest rate and principal cash flows are exchanged in two different currencies. The mechanism is identical to an IRS except that at start and at maturity an exchange takes place between the underlying notional amounts at the spot rate. Assuming that Corporate A wants to transform USD 50 million floating rate debt into fixed rate Deutsche Mark loan :

USD 6 Month Libor==>  Corporate A==>    USD 6 Month Libor===>    DEM fixed rate ===>  <== Credit Agricole Indosuez

The USD interest is calculated on USD 50 million whereas the DEM flows are computed on the equivalent DEM amount , that is, the USD notional times the spot exchange rate. If the latter is, for example, 1.80 the DEM notional will amount to DEM 90 million.These notionals are exchanged, that is Corporate A receives at start and pays at maturity DEM 90 million against USD 50 million:

At maturity :

Corporate A    <=== USD 50 million  <==  Credit Agricole Indosuez

Corporate A ==> DEM 90 million  ==>  Credit Agricole Indosuez


Corporate A thus effectively pays DEM interest and, at maturity, a DEM notional, which together make up the cash flows of a normal DEM loan.

Exchange of notional amounts between the counterparties on the start date of the swap is not obligatory, but it should be agreed between the parties prior to dealing.

Parameters

·                           Start date

·                           Maturity date

·                           The exchange rate used between the two currencies

·                           The notional amounts on which the interest flows are calculated

·                           The exchange of notional amounts at maturity

·                           Exchange, or not, of notional amounts at start date

·                           The frequency of the interest payments (Quarterly, Semi-annual or Annual)

·                           The interest rate basis (Money market, Bond Basis)

Example2 

Suppose a manufacturer, XYZ Company, is building a new plant in Germany using term fixed rate financing. Suppose further that XYZ, having little access to the German capital markets, concludes that borrowing US Dollars from a domestic bank offers the most cost-effective source of financing. Additionally, the domestic loan will be based on floating rate LIBOR for a 7 year term.

XYZ can fund in US Dollars (USD) and then convert to Deutsche Marks (DM) using a Cross Currency Swap. XYZ will make an initial exchange of USD for DM at the current spot exchange rate with an agreement to re-exchange at the same rate when the swap terminates in 7 years. In this way, the company is not exposed to exchange rate risk when closing out the swap and paying down the loan. 

During the life of the swap, the DM interest payment due from the company is tied to an agreed upon fixed rate while the USD amount paid to their counterparty is tied to LIBOR. The LIBOR interest payment that XYZ receives will offset the LIBOR based payment on the loan. In effect, the company is left with a fixed interest payment based on a fixed DM amount. This payment is funded by DM cash flow from the new plant. In sum, XYZ is insulated from both exchange rate and interest rate risk.

This example is for illustrative purposes only and may not reflect current economic conditions or realities. This is not an offer to sell or a solicitation of an offer to purchase any security or other financial instrument described herein. Foreign exchange and interest rate derivatives involve a high degree of risk including, but not limited to, loss of principal, and may not be suitable for all investors or customers.

EXAMPLE 3

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