Cross currency swap refers to an agreement between two parties to trade currencies. Over the duration of the swap, the interest payments are exchanged periodically, with the equal value principal exchanged at the origin and maturity.
How Does Cross Currency Swap Work?
Cross currency swap is based on comparative advantages of borrowing. Borrowers can get the lowest cost of borrowing on their domestic currency but will be faced with a higher cost for borrowing foreign currencies. Therefore, cross currency swap works by finding a counterparty from a foreign country that can borrow at their domestic advantageous rate. At the same time, the party borrows at their domestic rate, and immediately the two parties swap debt obligations.
In this example, Party A enjoys a comparative advantage over Party B in borrowing C$, but Party A wants to borrow $. On the other hand, Party B has an advantage over Party A in borrowing $, but they want to borrow C$. If they enter a cross currency swap, both parties can enjoy more favorable rates.
Quality Spread Differential
A way to calculate the potential gain from trade is by determining the quality spread differential (QSD).
QSD = $(7% – 6%) – C$(9% – 10%) = 2%
Through a cross currency swap, the two parties can enjoy a combined 2% gain from trade.
The principal (of equal amount) is swapped at year 0, and interest payments are paid by the counterparty over the term. At maturity, both the principal and interest on the foreign currency are repaid by the counterparty, which ends the swap obligation. The after-swap cash flow is the same as if the parties could borrow at the domestic rate of the foreign currency.
Party A borrows at 9% C$ and swaps the debt with Party B, who borrows at 6% $. Each party saves 1% compared to if they had borrowed at their available foreign rate. Party B’s cash flows are the exact opposite of Party A’s.
Realistically, it is very hard to personally find a counterparty that needs the same amount and maturity in the foreign market. Therefore, an intermediary swap bank is usually present – they help find a counterparty to fit your needs, facilitate the exchange of cash flows and take on some risk. In exchange, swap banks take a fee for their services. This fee must be smaller than the quality spread differential; otherwise, there would be no incentive for the parties to enter the swap.
Benefits of Cross Currency Swap
Gain From Trade (QSD)
The most obvious benefit of a cross currency swap is being able to borrow at a lower rate than from the available foreign rate.
Eliminates Foreign Currency Exposure
An alternative method of receiving foreign currency cash flows is by borrowing at the domestic currency and exchanging the cash flows at the spot rate (current exchange rate). The risk from using such a method is the dependency on the spot rate. If the spot rate fluctuates unfavorably, the party can end up paying a lot more than if they originally borrowed at the higher available foreign rate. With a cross currency swap, parties can cement the exchange rate at origin, so the cash flows are known.
Risk of Cross Currency Swap
Counterparty Default Risk
While cross currency swaps present compelling benefits, it also creates a new risk. If the counterparty to the swap fails to meet their payments, the party cannot pay their loan. Such a risk is mitigated through cross currency swaps with a swap bank present, which can thoroughly assess party creditworthiness and their ability to meet their obligations.