Currency and cross-currency swaps

Australian companies and banks often borrow in US dollars, where the bond market is deepest. But they earn Australian dollars. Borrow in one currency, earn in another, and a fall in your currency can make your debt balloon. The cross-currency swap lets them take the cheap foreign money and still owe their own.

You met the FX swapA spot exchange of two currencies combined with a forward deal to swap them back later. Usually short-term, with no interest payments in between. in L1.6.02: swap two currencies today at the spot rate and agree to swap them back on a later date at the forward rate. Banks use FX swaps every day to borrow one currency against another for days or months. No interest is paid in between; the interest difference is built into the forward rate.

A cross-currency swapA swap that exchanges principal in two currencies at the start and back at the end, at the same rate, with interest paid in each currency in between. does the same job for years. It has three parts:

1. At the start, the two sides exchange principalThe amount borrowed or lent. In a cross-currency swap it is actually exchanged, unlike the notional of an interest rate swap. amounts in the two currencies, at the spot rate.
2. During the life, each side pays interest on the principal it received, in that currency. Each leg can be fixed or floating.
3. At maturity, they swap the principals back at the same rate as at the start.

Compare this with the interest rate swap of L1.7.04, where the notional never moves and only interest is exchanged, all in one currency. Here real principal changes hands, twice.

How a borrower uses it. An Australian company sells a 5-year bond for USD 100.00m with a 5.0% fixed coupon. It needs Australian dollars, so it enters a cross-currency swap with its bank. Step through the three stages:

The US dollar flows cancel out: the bank pays the company exactly what the company owes its bond investors. What is left is a plain Australian dollar loan: AUD received at the start, AUD interest each year, AUD repaid at the end. The company has turned USD debt into AUD debt.

Bigger counterparty risk. In an interest rate swap only interest differences are at stake. In a cross-currency swap, a whole principal is swapped back at an old exchange rate. If the currency moves a long way, one side is owed a large sum by the other, and the exposureWhat you would lose if the other side failed today: the value of the contract to you, if positive. to the bank failing grows with it. That is why cross-currency swaps between banks are usually backed by collateral.

Here is the company's USD 100.00m bond, swapped into AUD at 0.65. Move the exchange rate and compare the total Australian dollars paid for coupons and principal, with and without the swap. For simplicity, the rate jumps straight to your chosen level and stays there.

USD 100.00m bond, 5 years, 5.0% annual coupon. Spot AUD/USD is 0.65 (US dollars per Australian dollar). The bank's fixed AUD rate for a 5-year swap is 4.6%. Rates are illustrative.

Most cross-currency swaps are not centrally cleared, so between financial firms they fall under the BCBS-IOSCO margin rules for non-centrally cleared derivatives (L1.7.11). Variation margin applies, while the fixed exchanges of principal are exempt from initial margin, in the same way as physically settled FX forwards. Banks also hold capital against the counterparty exposure, which later levels cover.

• A cross-currency swap exchanges principal at the start, interest in each currency during its life, and principal back at the end at the original rate.
• An FX swap is the short-term version: a spot exchange and a forward to reverse it, with no interest paid in between.
• Borrowers use cross-currency swaps to turn foreign-currency debt into home-currency debt.
• The swap fixes the home-currency cost, removing both the loss and the gain from currency moves.
• Because principal is swapped back at an old rate, currency moves create large exposures, so these swaps are usually collateralised.

FX swap

A spot exchange of two currencies combined with a forward deal to swap them back later. Usually short-term, with no interest payments in between.

Cross-currency swap

A swap that exchanges principal in two currencies at the start and back at the end, at the same rate, with interest paid in each currency in between.

Principal

The amount borrowed or lent. In a cross-currency swap it is actually exchanged, unlike the notional of an interest rate swap.

Cross-currency basis

An extra spread added to one floating leg of a cross-currency swap. It shows how much more one side will pay to borrow a currency, often the US dollar, through the swap market.

Exposure

What you would lose if the other side failed today: the value of the contract to you, if positive.