Cross Currency Swaps, Part 1

A cross currency swap (“CCS”, also known as a “currency swap” or “interest and currency swap”) is an instrument for active interest rate management, used since the 1980s by large companies and family-owned businesses in Germany.

A CCS can be employed, e.g. to make use of interest rate advantages vis-à-vis the home currency. Cross currency swaps are commonly used in connection with the EUR/JPY and the EUR/CHF exchange rates, as these currencies offer nominally lower interest rates as compared to the euro. To take advantage of this, a CCS is concluded for existing fixed-rate debt (e.g. in EUR), so that a lower foreign interest rate (e.g. in CHF) can be realised “after the fact”. A CCS subjects the client to unlimited currency risk in terms of both interest payments and periodic principal repayment (amortisation swap) or return of the nominal amount at maturity.

Fundamentally, a CCS is an exchange of interest payments in the two currencies. Moreover, the nominal amount is generally exchanged at the end of the transaction period, based on a fixed exchange rate agreed in advance (usually the current spot price).

A conventional CCS comprises three sub-transactions:

• The initial exchange^[1]
• Interest payment(s)
• Final exchange

In practice, there is usually no actual initial exchange of currencies.

Figure 1: Payment flows of a CCS EUR/CHF as seen in sals.a (without initial exchange; with return of the nominal amount)

In the example, two fixed interest rates (EUR = 4.5% p.a. and CHF = 3.5% p.a.) are swapped. A swap can also involve variable interest rates for one or both of the currencies (known as a “basis swap”).

Figure 2: Interest payments for the EUR/CHF-CCS (exchange of nominal amount not included)

The payment flows depicted in figure 2 result from a long-term financing transaction in EUR. Sample plc pays interest on the nominal CHF amount at a fixed rate in CHF. If the EUR/CHF exchange rate remains stable, the CCS results in a lower interest burden from the EUR-denominated loan.

Appreciation of CHF, on the other hand, reduces the interest rate advantage, as more CHF must be purchased at a higher price on the market. Final exchange takes place at current EUR/CHF spot rate. The risk of loss is not quantifiable – nor is the potential gain. Thus, the risk profile must be analysed precisely, in order to avoid unwelcome surprises.

Although CCS transactions can be concluded for maturities of 1 to 30 years, the company has the flexibility to terminate a CCS during the term. The market value of a CCS changes daily, based on the market situation, so that the bank has to pay the company the difference upon termination of the transaction if the market value is positive, or vice versa in the case of a negative market value.

By the way: cross currency swaps bear a resemblance to forward currency transactions, but the two should not be confused. Unlike a CCS, a forward transaction involves the exchange of the principal amount only at maturity, with no interest payments made during the term. Discount or premium in the forward rate is the equivalent of an interest rate differential under a currency swap.

In our next issue, read details about possibilities for practical application to your specific needs.

Footnote

1. A CCS with an initial exchange of currencies is used for foreign-currency debt, and involves immediate conversion of the foreign currency amount into the home currency, e.g. in connection with financing transactions on the US private placement market.

• The fundamentals of diesel hedging, Pt 2
• Cross Currency Swaps, Pt.2