The cross currency swap is an OTC (over the counter) derivative which takes form of an agreement between two parties. It is done in exchange of payments of interest and the principal amount. The denomination used is of two different countries. During the agreement, there are regular exchanges of the interest payments. These cross-currency swaps are very well customizable and can be inclusive of fixed interest rates, variable rates and also both.
Since there is an exchange of money this does not appear on the balance sheet of a company.
Exchange of Principal Amount
At the beginning of the agreement, the exchange used, is same the exchange used at the end of the agreement. For instance in case a swap has one company giving another a sum of £10 billion in exchange for $13.4 billion, the rate is 1.34 GBP/USD. If the agreement stands for 10 years, when it lapses, the same amounts shall be exchanged by the two companies. The exchange rate shall remain constant. While in the market, after such a long time the rates shall be drastically different. The same could have caused gains or opportunity costs.
Alternatively, the agreement may state marking to market of the notional loan amounts. This implies that with the fluctuation in exchange rates, there is transfer of small amounts of money between the two companies. This helps keep the amount of loan the same as per marked to the market.
Exchange of Interest
A cross currency may involve both parties paying either a floating or a fixed rate, or even one party with the fixed and the other with a floating rate. Since these are OTC products, the structuring is as per what the two parties agree to. Typically, there is quarterly calculation of interest payments.
Interest payments settle in cash, generally. Each payment is in a different country so they are not netted. Therefore, on the due date, each company makes a payment of the specified amount in the currency they owe it in.
Uses of Currency Swaps
There are majorly 3 ways for using currency swaps.
- Purchase of a less expensive debt. One party gets the best rate available in any particular currency and can exchange it for a higher amount in the desired currency having back to back loans.
- It can be used for the purpose of hedging against fluctuations in the foreign exchange rate.
- It can be used by a nation to defend against a financial crisis.