Cross currency swap

The way the swap agreement works is this: the first party borrows a specific amount of foreign currency from the counterparty at the current exchange rate. In turn, it lends a corresponding amount to the counterparty of its own currency. Both parties pay interest to each other throughout the duration of the contract in the currencies that they both received. Interest rates are calculated according to each currency index and can be fixed, variable or both. Currencies traded usually include the major forex pairs​, such as USD/EUR and USD/JPY. The counterparties involved in a cross currency swap are usually institutional investors​.

There are three principal objectives for trading cross currency swaps, as follows:

Below is an example of a cross currency basis swap between a Japanese counterparty and an American counterparty, with the corresponding forex pair USD/JPY​​.

Let’s say that the Japanese party is looking to borrow US$100 million and, in turn, lends ¥50 million to the American party. This is a spot exchange rate of US$2 per JPY, which is indexed to the London Inter-bank Offered Rate (LIBOR) when the contract begins.

Throughout the duration of the contract, the Japanese party receives interest payments in JPY from its counterparty, plus a basis swap price. Interest payments are usually paid on a quarterly basis. In turn, it pays the American counterparty the notional amount in USD at the Libor interest rate. Both parties can agree to keep the interest rates fixed, or if they prefer, allow interest rates to fluctuate based on the economic conditions of each country.

When the contract comes to an end, the Japanese company will pay the full principal amount of US$100 million back to the American company, and will receive the full exchange price back of ¥50 million.

Although they share similarities with other products, such as FX swaps and FX forwards​​, there are notable differences that set cross currency trades aside.

Cross currency basis swaps are currency derivatives, largely focused on interest payments. On the other hand, forex swaps do not exchange any interest between parties, and the amount of principal exchanged at the end of a contract is of a different value to the beginning. Both forex instruments are used by large corporations and institutional investors. Cross currency swaps can be seen as long-term instruments, as their contracts can often span for decades, whereas investors can trade FX swaps for as little as a day, making them more suitable for short-term investing. As forex swaps do not deal with interest payments, they cannot be used to offset interest-rate risks.

Cross currency swaps are generally difficult to value, due to the different funding costs for each currency. Traditional trading rules would assume that the funding cost in each currency is equal to its floating rate, therefore giving a zero cross currency spread​​. However, investors have differing levels of access to different currencies around the world, and therefore, funding costs are not calculated the same as in the LIBOR, where we tend to calculate interest rates for UK trading.

Investors have found a way to work around this. They can now select one currency as the funding currency and select one curve in this currency to be the discount curve. Future cash flows are then discounted at the market interest rate that is applicable at the time of valuation. The sum of the cash flows from the foreign currency are swapped into the funding currency at its spot price, and then discounted afterwards. Cross currency swaps differ to other interest-rate derivatives in that there will always be an exchange of a notional or face value amount.

Cross currency basis swaps can be used effectively to hedge currency risk within the forex market. They may not be particularly suitable for short-term traders, who tend to prefer a simpler instrument such as an FX swap. However, for institutional investors and large corporations who deal with foreign currency trading on a frequent and international scale, this may be the perfect solution for forex traders.