A cross-currency swap's (XCS's) effective description is a derivative contract, agreed between two counterparties, which specifies the nature of an exchange of payments benchmarked against two interest rate indexes denominated in two different currencies. It also specifies an initial exchange of notional currency in each different currency and the terms of that repayment of notional currency over the life of the swap.[1]
The most common XCS, and that traded in interbank markets, is a mark-to-market (MTM) XCS, whereby notional exchanges are regularly made throughout the life of the swap according to FX rate fluctuations. This is done to maintain a swap whose MTM value remains neutral and does not become either a large asset or liability (due to FX rate fluctuations) throughout its life.
The more unconventional, but simpler to define, non-MTM XCS includes an upfront notional exchange of currencies with a re-exchange of that same notional at maturity of the XCS.
The floating indexes are commonly the 3-month tenor EURIBOR, and compounded overnight rates.
Each series of payments (either denominated in the first currency or the second) is termed a 'leg', so a typical XCS has two legs, composed separately of interest payments and notional exchanges. To completely determine any XCS a number of parameters must be specified for each leg; the notional principal amount (or varying notional schedule including exchanges), the start and end dates and date scheduling, the chosen floating interest rate indexes and tenors, and day count conventions for interest calculations.
The pricing element of a XCS is what is known as the basis spread, which is the agreed amount chosen to be added (or reduced in the case of a negative spread) to one leg of the swap. Usually this is the domestic leg, or non-USD leg. For example a EUR/USD XCS would have the basis spread attached to the EUR denominated leg.
A cashflows diagram of EUR100mm EUR/USD non-MTM XCS with initial EURUSD FX fixing of 1.200.
A cashflows diagram of EUR mm EUR/USD MTM XCS with initial EURUSD FX fixing of .
Extended description
As OTC instruments, cross-currency swaps (XCSs) can be customised in a number of ways and can be structured to meet the specific needs of the counterparties. For example; payment dates could be irregular, the notional of the swap could be amortized over time, reset dates (or fixing dates) of the floating rate could be irregular, mandatory break clauses may be inserted into the contract, FX notional payments and FX rates may be manually specified etc.
Additionally it is not a requirement for swaps to have two floating legs. This leads to the naming convention of different types of XCS:
(Floating v Floating) Cross-Currency Swaps: are the normal, interbank traded products. These are over-the-counter (OTC) products and commonly referred to as basis swaps.[2]
(Fixed v Floating) Cross-Currency Swaps: are a common customization of the benchmark product, often synthesized or hedged by market-makers by trading a float v float XCS and a standard interest rate swap (IRS) to convert the floating leg to a fixed leg.
(Fixed v Fixed) Cross-Currency Swaps: a less common customization, again synthesized by market makers trading two IRSs in each currency and a float v float XCS.
Mark-to-Market or Non Mark-to-Market: the MTM element and notional exchanges are usually standard (in interbank markets) but the customization to exclude this is available.
Non-deliverable Cross-Currency Swap (NDXCS or NDS): similar to a regular XCS, except that payments in one of the currencies are settled in another currency using the prevailing FX spot rate. NDS are usually used in emerging markets where the currency is illiquid, subject to exchange restrictions, or even non-convertible. This associates with quantos.
Embedded options: exotic customization options exist potentially with FX options at the maturity of the trade, or swaptions.[3]
To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).
To hedge against (reduce exposure to) forward exchange rate fluctuations.
Cross-currency swaps are an integral component in modern financial markets as they are the bridge needed for assessment of yields on a standardised USD basis. For this reason they are also used as the construction tool in creating collateralized discount curves for valuing a future cashflow in a given currency but collateralized with another currency. Given the importance of collateral to the financial system at large, cross-currency swaps are important as a hedging instrument to insure against material collateral mismatches and devaluation.
Hedging example one
For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging either of the following:
If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency.
Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.
Hedging example two
Suppose the British Petroleum Company plans to issue five-year bonds worth £100 million at 7.5% interest, but actually needs an equivalent amount in dollars, US$150 million (current $/£ rate is $1.50/£), to finance its new refining facility in the U.S. Also, suppose that the Piper Shoe Company, a U. S. company, plans to issue US$150 million in bonds at 10%, with a maturity of five years, but it really needs £100 million to set up its distribution center in London. To meet each other's needs, suppose that both companies go to a swap bank that sets up the following agreements:
Agreement 1:
The British Petroleum Company will issue 5-year £100 million bonds paying 7.5% interest. It will then deliver the £100 million to the swap bank who will pass it on to the U.S. Piper Company to finance the construction of its British distribution center. The Piper Company will issue 5-year US$150 million bonds paying 10% interest. The Piper Company will then pass the $150 million to swap bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its U.S. refinery.
Agreement 2:
The British company, with its U.S. asset (refinery), will pay the 10% interest on US$150 million (US$15 million) to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. The American company, with its British asset (distribution center), will pay the 7.5% interest on £100 million (.075 × £100m = £7.5), to the swap bank who will pass it on to the British company so it can pay its British bondholders.
Agreement 3:
At maturity, the British company will pay US$150 million to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. At maturity, the American company will pay £100 million to the swap bank who will pass it on to the British company so it can pay its British bondholders.
Valuation and pricing
It is well recognized[4][5] that traditional "textbook" theory does not price cross currency (basis) swaps correctly, because it assumes the funding cost in each currency to be equal to its floating rate, thus always giving a zero cross currency spread. This is clearly contrary to what is observed in the market. In reality, market participants have different levels of access to funds in different currencies and therefore their funding costs are not always equal to LIBOR.[citation needed]
An approach to work around this is to select one currency as the funding currency (e.g. USD), and select one curve in this currency as the discount curve (e.g. USD interest rate swap curve against 3M LIBOR). Cashflows in the funding currency are discounted on this curve. Cashflows in any other currency are first swapped into the funding currency via a cross currency swap and then discounted.[5]
XCSs expose users to many different types of financial risk.[6]
Predominantly they expose the user to market risks. The value of a XCS will change as market interest rates, FX rates, and XCS rates rise and fall. In market terminology this is often referred to as delta and basis risks. Other specific types of market risk that interest rate swaps have exposure to are single currency basis risks (where various IBOR tenor indexes can deviate from one another) and reset risks (where the publication of specific tenor IBOR indexes are subject to daily fluctuation). XCSs also exhibit gamma risk whereby their delta risk, basis risks or FX exposures, increase or decrease as market interest rates fluctuate.
Uncollateralised XCSs (that are those executed bilaterally without a credit support annex (CSA) in place) expose the trading counterparties to funding risks and credit risks. Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded. Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about the opposing counterparty defaulting on its obligations.
Collateralised XCSs expose the users to collateral risks. Depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements. Credit and funding risks still exist for collateralised trades but to a much lesser extent.
Due to regulations set out in the Basel III Regulatory Frameworks trading interest rate derivatives commands a capital usage. Dependent upon their specific nature XCSs might command more capital usage and this can deviate with market movements. Thus capital risks are another concern for users.
Reputation risks also exist. The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR manipulation are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators.
Hedging XCSs can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks. The other, aforementioned risks must be hedged using other systematic processes.
Market-making
The market-making of XCSs is an involved process involving multiple tasks; curve construction with reference to interbank markets, individual derivative contract pricing, risk management of credit, cash and capital. The cross disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach towards profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis. The time sensitive nature of markets also creates a pressurized environment. Many tools and techniques have been designed to improve efficiency of market-making in a drive to efficiency and consistency.[6]
In the 1990s Goldman Sachs and other US banks offered Mexico, currency swaps and loans using Mexican oil reserves as collateral and as a means of payment. The collateral of Mexican oil was valued at US$23.00 per barrel.
In May 2011, Charles Munger of Berkshire Hathaway Inc. accused international investment banks of facilitating market abuse by national governments. For example, "Goldman Sachs helped Greece raise US$1 billion of off- balance-sheet funding in 2002 through a currency swap, allowing the government to hide debt."[7] Greece had previously succeeded in getting clearance to join the euro on 1 January 2001, in time for the physical launch in 2002, by faking its deficit figures.[8]
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling.[9] While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage.
The first formal currency swap, as opposed to the then used parallel loans structure, was transacted by Citicorp International Bank for a US$100,000,000 10 year US Dollar Sterling swap between Mobil Oil Corporation and General Electric Corporation Ltd (UK). The concept of the interest rate swap was developed by the Citicorp International Services unit in 1980 but cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of US$210 million and a term of over ten years.[10]
During the 2007–2008 financial crisis, the currency swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central bank of a developed[11] or stable emerging[12] economy agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S. dollars to overseas markets".[13] While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term.[14]
South Korea and Indonesia signed a won-rupiah currency swap deal worth US$10 billion in October, 2013. The two nations can exchange up to 10.7 trillion won or 115 trillion rupiah for three years. The three-year currency swap could be renewed if both sides agree at the time of expiration. It is anticipated to promote bilateral trade and strengthen financial cooperation for the economic development of the two countries. The arrangement also ensures the settlement of trade in local currency between the two countries even in times of financial stress to support regional financial stability. As of 2013, South Korea imported goods worth US$13.2 billion from Indonesia, while its exports reached US$11.6 billion. In August 2018, Qatar and Turkey's central banks signed a currency swap agreement to provide liquidity and support for financial stability.[citation needed]
Japan and India signed a currency swap agreement worth US$75 billion in October, 2018, which has been one of the largest bilateral currency swap agreements.[19]
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, currency, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.
The derivatives market is the financial market for derivatives - financial instruments like futures contracts or options - which are derived from other forms of assets.
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).
In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives.
In finance, a swap is an agreement between two counterparties to exchange financial instruments, cashflows, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.
In finance, an interest rate derivative (IRD) is a derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.
Over-the-counter (OTC) or off-exchange trading or pink sheet trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily publicly disclosed.
An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs.
In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.
A quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate risk.
In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It is used in various markets such as foreign exchange and commodities. NDFs are also known as forward contracts for differences (FCD). NDFs are prevalent in some countries where forward FX trading has been banned by the government.
A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.
Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation.
A dual-currency note (DC) pays coupons in the investor's domestic currency with the notional in the issuer's domestic currency. A reverse dual-currency note (RDC) is a note which pays a foreign interest rate in the investor's domestic currency. A power reverse dual-currency note (PRDC) is a structured product where an investor is seeking a better return and a borrower a lower rate by taking advantage of the interest rate differential between two economies. The power component of the name denotes higher initial coupons and the fact that coupons rise as the foreign exchange rate depreciates. The power feature comes with a higher risk for the investor, which characterizes the product as leveraged carry trade. Cash flows may have a digital cap feature where the rate gets locked once it reaches a certain threshold. Other add-on features include barriers such as knockouts and cancel provision for the issuer. PRDCs are part of the wider Structured Notes Market.
LCH is a financial market infrastructure company headquartered in London that provides clearing services to major international exchanges and to a range of OTC markets. The LCH Group includes two main entities: LCH Limited based in London and LCH SA based in Paris.
An X-Value Adjustment is an umbrella term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into. The purpose of these is twofold: primarily to hedge for possible losses due to other parties' failures to pay amounts due on the derivative contracts; but also to determine the amount of capital required under the bank capital adequacy rules. XVA has led to the creation of specialized desks in many banking institutions to manage XVA exposures.
In finance, a zero coupon swap (ZCS) is an interest rate derivative (IRD). In particular it is a linear IRD, that in its specification is very similar to the much more widely traded interest rate swap (IRS).
1 2 Fujii, Masaaki Fujii; Yasufumi Shimada; Akihiko Takahashi (26 January 2010). "A Note on Construction of Multiple Swap Curves with and without Collateral". CARF Working Paper Series No. CARF-F-154. SSRN1440633.
1 2 Darbyshire, J. H. M. (2017). Pricing and trading interest rate derivatives: a practical guide to swaps (Revised, seconded.). Nottinghamshire, United Kingdom: Aitch & Dee. ISBN978-0-9954555-2-8. OCLC1089997510.
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