Cross Currency Swaps, Part 2
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We continue our CCS article with an application-oriented risk/return analysis (read the part 1 of this article here).
Cross currency swaps (CCS) offer a broad range of applications:
- A combination of newly concluded foreign currency financing transaction with a CCS allows hedging of payments in the home currency
- Companies that prepare their financial statements in accordance with IFRS can hedge income and/or expenditures in connection, e.g. with subsidiaries abroad, against exchange rate volatility using a CCS
- In currency management, the CCS is often used in lieu of long-term currency forwards
- A subsequent reduction[1] (not risk-free!) of financing interest payments in the home currency through conversion to the lower foreign currency rate.
As the basis for an application-oriented risk/return analysis, we will use the CCS already introduced in the December issue of sals.a Educational Research:
- The hedged transaction is a fixed interest loan in EUR (4.5% p.a.) plus
- a CCS, under which the customer receives 4.5% (EUR) and pays 3.5% (CHF)
Fig. 1: Cross currency swap in sals.a
The transaction parameters for the CCS are also available under sals.a-Templates -> Sample Portfolios
In the overview 1+2, the aim is to achieve a reduction in the effective interest rate. Bankers often refer to this structure as a "synthetic CHF loan”.
Fig. 2: Graphical representation of CCS and loan
| Transaction parameters | |||
|---|---|---|---|
| Loan in EUR | EUR/CHF cross currency swap | ||
| Receive (EUR) | Pay (CHF) | ||
| Nominal | 1 000 000 | 1 000 000 | 1 571 300 |
| Payment date | 17 Dec 2008 | 17 Dec 2008 | 17 Dec 2008 |
| Maturity | 17 Dec 2018 | 17 Dec 2018 | 17 Dec 2018 |
| Frequency | Annually | Annually | Annually |
| Interest rate | 4.50% | 4.50% | 3.50% |
| Overview: EUR loan plus EUR/CHF CCS | |||||
|---|---|---|---|---|---|
| Period | 1. Loan in EUR | 2. EUR/CHF (fixed/fixed) CCS | |||
| Receive (EUR) | Pay (CHF) | 1+2 converted to CHF | 1+2 converted to EUR* | ||
| 2009 | -45 000 | 45 000 | -54 996 | -54 996 | -36 269 |
| 2010 | -45 000 | 45 000 | -54 996 | -54 996 | -36 777 |
| 2011 | -45 000 | 45 000 | -54 996 | -54 996 | -37 278 |
| 2012 | -45 000 | 45 000 | -54 996 | -54 996 | -37 772 |
| 2013 | -45 000 | 45 000 | -54 996 | -54 996 | -38 187 |
| 2014 | -45 000 | 45 000 | -54 996 | -54 996 | -38 658 |
| 2015 | -45 000 | 45 000 | -54 996 | -54 996 | -39 141 |
| 2016 | -45 000 | 45 000 | -54 996 | -54 996 | -39 681 |
| 2017 | -45 000 | 45 000 | -54 996 | -54 996 | -40 236 |
| 2018 | -1 045 000 | 1 045 000 | -1 626 296 | -1 626 296 | -1 206 701 |
* based on forward prices as at 17 December 2008
Four weeks after our initial article on cross currency swaps, a look at the derivative structure reveals a negative market value of EUR -75K. The EUR/CHF exchange rate (currently 1.5402 EUR/CHF) has its greatest impact on the final exchange amount, as a result of the nominal volume. Market value is calculated based on the currency forward rate applicable on the payment date (see figure 3). The average forward rates on 27 January are above the break-even threshold, and thus imply a negative market value.
A cash flow-oriented break even analysis can be used as a simple means to demonstrate the currency risk. On 17 December, the swap was concluded at the exchange rate 1.5713 EUR/CHF. Based on the payments to be made in CHF at a fixed amount of CHF 55K p.a., it is obvious that more EUR per CHF must be paid in the event of a falling EUR/CHF exchange rate to service the agreed CHF coupon. In this case, a CHF interest rate advantage is overturned as soon as the EUR/CHF spot price falls below 1.4630 EUR/CHF (figure 3).
Fig. 3: Simplified currency analysis of the cross currency swap
Fig. 4: Risk component analysis
| Period | Current payments in EUR | EUR scenarios | CHF scenarios | EUR/CHF scenarios | |||
|---|---|---|---|---|---|---|---|
| Interest +100 bps | Interest -100 bps | Interest +100 bps | Interest -100 bps | Exchange rate +10% | Exchange rate -10% | ||
| 2009 | -36 269 | 0 | 0 | 0 | 0 | 3 297 | -4 030 |
| 2010 | -36 777 | 0 | 0 | 0 | 0 | 3 343 | -4 086 |
| 2011 | -37 278 | 0 | 0 | 0 | 0 | 3 389 | -4 142 |
| 2012 | -37 772 | 0 | 0 | 0 | 0 | 3 434 | -4 197 |
| 2013 | -38 187 | 0 | 0 | 0 | 0 | 3 472 | -4 243 |
| 2014 | -38 658 | 0 | 0 | 0 | 0 | 3 514 | -4 295 |
| 2015 | -39 141 | 0 | 0 | 0 | 0 | 3 558 | -4 349 |
| 2016 | -39 681 | 0 | 0 | 0 | 0 | 3 607 | -4 409 |
| 2017 | -40 236 | 0 | 0 | 0 | 0 | 3 658 | -4 471 |
| 2018 | -1 206 701 | 0 | 0 | 0 | 0 | 109 700 | -134 078 |
A risk component analysis makes clear the effect of the exchange rate on the payment advantage or disadvantage under the CCS (figure 4). During the term, both the interest payments in CHF and the exchange at the end of the term are subject to – virtually unlimited – currency risk. A 10% movement up or down in EUR/CHF results in the above changes in interest payments and the final exchange.
- The idea of interest-reduction can be misleading. In the overview below, this term is not meant to denote “risk-free reduction of interest payments”. In order to reduce interest payments in the overview, derivatives are used, which entails a separate risk. Thus, the initial temporary reduction in interest payments can lead to a significant increase in certain cases. It is absolutely necessary that this possibility be addressed in the consultation between the bank and the customer.