A cross currency swap is similar to a Vanilla Swap but gives each counterparty access to a different foreign currency. That is, one counterparty makes payments in one currency; the other makes payments in a different currency.
Because there are two currencies involved, the payments may not only include interest rate payments (on the set payment periods in the relevant currency on the respective principal) but also an exchange of principals (i.e., a foreign exchange position).
You can specify that principals should be exchanged at the:
Start date
End date
Both the start date and the end date
Neither date
Normally the same spot rate (determined on the trade date) is used for the exchanges throughout the trade.
In an amortized cash flow, when you choose to exchange principals on the end date, the amortized principal amount (i.e., the amount the principal changed by) will be paid/received on the amortization dates.
It is important to note that if you enter into a deal which has an exchange of principals either on the start and the end date or just on the start date, and you price it after its start date, then the exchange on the start date is not taken into account in the FX exposure (assuming it is in the cash account).
Accordingly, such a deal with an exchange on the start and end date will only show the risk of the exchange on the end date (this will be the full notional amount plus interest), whereas a deal with an exchange only on the start date will only show the risk of the interest amounts.
Advantages of a Cross Currency Swap
A cross-currency swap:
Lets you convert a liability or an asset from one currency to another currency, with reduced costs.
Is a simple and effective solution to long-term currency hedging needs.
There are three main target markets for cross currency swaps:
Investors who wish to purchase foreign assets but seek to eliminate foreign currency exposure.
Debt issuers who can achieve more favorable rates by issuing debt in foreign currency.
Liability managers seeking to create synthetic foreign currency liabilities.
Example of a Cross Currency Swap
A US corporate wants to borrow euros to finance an acquisition in Europe. The corporate is well known in the US, but not well known in Europe. As a result, the interest rates that the corporate would have to pay in the US would be preferential to those in Europe. However, the corporate requires Euros and can only borrow USD in the US.
As a solution, the corporate could simultaneously:
Take out a USD loan in the US.
Enter into a USD/EUR cross currency swap with a European bank or other counterparty.
The transactions that would take place during the cross currency swap can be divided into three stages, as follows:
| 1. | The corporate enters into a cross currency swap with a European bank. The corporate swaps the USD principal that was borrowed in the US for a sum of Euros which it can then use to finance its acquisition. |
| 2. | Over the next ten years, the corporate: |
Pays interest in Euros to the European bank based on the amount of Euros received at the start of the swap. The corporate has Euros with which to pay the interest as a result of its new operations in Europe.
Receives, from the European bank, interest in USD based on the amount of USD transferred at the start of the swap. The corporate pays this received USD interest to the bank from which it borrowed the USD amount originally. Because the cross currency swap is traded OTC, the corporate can ensure that the dates on which it receives the USD interest match the dates on which it has to pay interest to the bank from which it borrowed the USD amount.
| 3. | At the end of the swap: |
The corporate transfers the amount of euros received at the start of the swap to the European bank, paying back that loan.
The European bank transfers the amount of USD it received at the start of the swap back to the corporate. The corporate can now return this amount to the US bank from which it borrowed the USD amount originally.
In effect, the corporate achieved its objective—its net cash flows are in euros as if it had borrowed euros in Europe, but at a lower interest rate.
Pricing a Cross Currency Swap in SDX Interest Rates
When pricing a cross currency swap in SDX Interest Rates note the following:
The price of the cross currency swap takes into account the cross currency basis spread market data, which defines the spread between the floating rate of each currency. You can see this data in the Basis Swap Curve window (which is accessed by clicking the Basis Swaps button in the pricing page).
For more information on this window see Basis Swap Curve Window.
You need to choose the type of floating leg(s)—either based on a Vanilla Swap or a General Swap.
By default the floating legs are based on a vanilla swap, but you can choose instead to set them to a general swap using the Vanilla <> General button.
If it is set to Vanilla, then the cross currency swap’s floating legs have the same constraints as a Vanilla Swap’s floating legs. That is, there is direct dependency between the reference index and the frequency of the fixing and payment dates. So, for example, if the floating leg’s reference index is based on 3m LIBOR, its fixing and payment frequency must be quarterly.
However, you can instead choose to break that dependency by setting it to General. Breaking the dependency gives you more flexibility and control over the index, and the fixing and payment frequencies. If you do this you can choose, for example, a reference rate of 6m Euribor, a semi-annual fixing frequency and a monthly payment frequency.
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When pricing a cross currency swap whereby for the floating leg(s) there is no dependency between the reference index, the frequency of the fixing dates and the frequency of the payment dates, the pricing model applies convexity adjustment when necessary for mismatches between the floating rate and the period over which it is accrued. |
Although each currency has its own default yield curve from which the discount factors (i.e., the factors that are used as a multiplier to convert a future cash flow to its present value) are calculated, for a cross currency swap, the discount factor for one of the two currencies (the non-flat currency) is taken from a cross currency curve which is based on the currency’s default curve plus the cross currency basis swap curve.
The cross currency basis swap curve is always associated with the currency according to the market convention—that is, in any given pair, the non-flat currency is defined according to market convention. So, for example, if the basis swap curve is for the 3M EUR Basis swaps vs 3M USD Flat, the cross currency basis swap curve is associated with the EUR (because in the EUR/USD currency pair the EUR is the non-flat currency).
For more information see the Basis Swap Curve Window.
The Spot field is linked to both the Notional fields. Accordingly, when you first define one of the notionals, by default the system automatically calculates the other notional using both the defined notional value and the spot rate displayed in the Spot field.
However, you can then overwrite each notional individually and/or change the spot rate. If you change the spot rate or change one of the notionals, you can subsequently instruct the system to re-calculate the other notional accordingly. For more information see Recalculating the Second Notional in a Cross Currency Swap.