Cross-currency swap

Cross-currency swap – In a currency swap operation, also known as a cross-currency swap, the parties involved agree under contract to exchange the following: the principal amount of a loan in one currency and the interest applicable on it during a specified period of time for a corresponding amount and applicable interest in a second currency.

  • Cross-currency swaps are used to lock in exchange rates for set periods of time. Cross-currency swap
  • Interest rates can be fixed, variable, or a mix of both. Cross-currency swap
  • These instruments trade OTC, and can thus be customized by the parties involved. Cross-currency swap
  • While the exchange rate is locked in, there is still opportunity costs/gains as the exchange rate will likely change. This could result in the locked-in rate looking quite poor (or fantastic) after the transaction occurs. Cross-currency swap
  • Cross-currency swaps are not typically used to speculate, but rather to lock in an exchange rate on a set amount of currency with a benchmarked (or fixed) interest rate.

Currency swaps are often used to exchange fixed-interest rate payments on debt for floating-rate payments; that is, debt in which payments can vary with the upward or downward movement of interest rates. However, they can also be used for fixed rate-for-fixed rate and floating rate-for-floating rate transactions.

Each side in the exchange is known as a counterparty. Cross-currency swap

Cross-currency swap

In a typical cross-currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received. Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another. Cross-currency swap

An example of a cross currency swap for a EUR/USD transaction between a European and an American company follows: Cross-currency swap

  • In a cross-currency basis swap, the European company would borrow USD1 billion and lend ‎EUR 500 million to the American company assuming a spot exchange rate of USD 2 per EUR for an operation indexed to the London Interbank Rate (LIBOR), when the contract is initiated. Cross-currency swap
  • Throughout the length of the contract, the European company would periodically receive an interest payment in EUR from its counterparty at LIBOR plus a basis swap price, and it would pay the American company in dollars at the LIBOR rate. When the contract comes to maturity, the European company would pay USD 1 billion in principal back to the American company and would receive its initial ‎EUR 500 million in exchange.

The Uses of Currency Swaps

First, currency swaps can be used to purchase less expensive debt. This is done by getting the best rate available of any currency and then exchanging it back to the desired currency with back-to-back loans.
Second, currency swaps can be used to hedge against foreign exchange rate fluctuations. Doing so helps institutions reduce the risk of being exposed to large moves in currency prices which could dramatically affect profits/costs on the parts of their business exposed to foreign markets.
Last, currency swaps can be used by countries as a defense against a financial crisis. Currency swaps allow countries to have access to income by allowing other countries to borrow their own currency.

Cross-currency swap

In a typical cross-currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received. Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another. Cr

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