In addition to hedging currency risk, this type of swap often helps borrowers get lower interest rates than they could get if they had to borrow directly from a foreign market. Cross-currency swaps are used to manage foreign exchange risk. In a currency swap, two counterparties exchange interest and principal payments for loans in different currencies. Counterparties agree on a fixed exchange rate, a fixed maturity and a fixed schedule for the payment of interest and principal. By setting the exchange rate of the transaction, both counterparties hedge the risk of adverse exchange rate fluctuations. For example, swaps are now most often made to hedge long-term investments and change the interest rate risk of both parties. Companies operating abroad often use cross-currency swaps to obtain cheaper lending rates in the local currency than if they could borrow money from a bank in that country. There are also reputational risks. Swap mis-selling, excessive exposure of municipalities to derivative contracts, and IBOR manipulation are high-profile examples of interest rate swap trading has resulted in reputational loss and fines from regulators.
Unsecured XCS (i.e. those executed bilaterally without a Credit Support Annex (CSA)) expose trading counterparties to financing and credit risks. Funding risks, because the value of the swap can become so negative that it is prohibitively expensive and cannot be financed. Credit risks, as the respective counterparty for which the value of the swap is positive will be concerned that the adverse counterparty will not meet its obligations. India and Japan signed a $75 billion bilateral currency swap agreement in October 2018 to bring stability to India`s foreign exchange and capital markets. One approach to work around this issue is to select a currency as the funding currency (for example, USD) and choose a curve in that currency as the discount curve (e.B USD interest rate swap curve versus 3M LIBOR). Cash flows in the refinancing currency are discounted on this curve. Cash flows in another currency are first exchanged in the refinancing currency via a cross-currency swap and then discounted. [5] See Interest Rate Swap § Valuation and Pricing for further discussion and description of the associated curve structure. Cross-currency swaps are used to obtain foreign currency loans at a better interest rate that a company could obtain through direct borrowing in a foreign market or as a method of hedging the transaction risk on foreign currency loans it has already taken out. A U.S. company can borrow in the U.S.
at an interest rate of 6%, but needs a Rand loan for an investment in South Africa, where the corresponding borrowing rate is 9%. At the same time, a South African company wants to finance a project in the United States, where its direct lending rate is 11%, compared to a borrowing rate of 8% in South Africa. Each party can benefit from the other party`s interest rate through a fixed-to-fixed currency swap. In this case, the US company can borrow US dollars for 6% and then lend the funds to the South African company at 6%. The South African company can borrow South African rand at 8%, and then lend the funds to the American company for the same amount. The main difference between the two is the payment of interest. A cross-currency swap requires both parties to make regular interest payments in the currency they are borrowing. Unlike a foreign exchange swap, where the parties own the amount they exchange, the currency swap parties lend the amount to their national bank and then exchange the loans. Swaps can last for years depending on the individual agreement, so the spot market exchange rate between the two currencies in question can change significantly over the life of the transaction. This is one of the reasons why institutions use cross-currency swaps. They know exactly how much money they will receive and will have to repay in the future.
If they need to borrow money in a particular currency and expect that currency to be significantly strengthened in the coming years, a swap will help limit their cost of repaying that borrowed currency. A currency swap, sometimes called a currency swap, involves the exchange of interest – and sometimes capital – in one currency for the same in another currency. Interest payments are exchanged on fixed dates for the duration of the contract. It is considered a foreign exchange transaction and is not required by law to be declared on a company`s balance sheet. Cross-currency swaps are valued or valued in the same way as interest rate swaps – using discounted cash flow analysis after obtaining the zero-coupon version of the swap curves. In the 1990s, Goldman Sachs and other U.S. banks offered currency swaps and loans to Mexico that used Mexican oil reserves as collateral and as a means of payment. The price element of an XCS is what is called the base spread, i.e. the agreed amount chosen to be added (or reduced in the case of a negative spread) to a part of the swap.
Usually, this is the domestic phase or the non-USD phase. For example, an XCS EUR/USD would have the base spread attached to the leg denominated in EUR. The purpose of a swap is to change a payment system to another type that better meets the needs or objectives of the parties, which may be individuals, investors or large companies. .