Cross currency swap
A cross currency swap, also referred to as cross currency interest rate swap or simply currency swap, is an agreement between two parties to exchange interest payments and principals denominated in two different currencies.
It is best to explain the structure of a cross currency swap with an example.
The chart above (to be completed) illustrates the flow of funds involved in a typical EUR/USD cross currency swap. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B. During the contract term, A receives EUR 3M Libor + α from, and pays USD 3M Libor to, B every three months, where α is called the cross currency basis or cross currency spread, and is agreed upon by the counterparties at the start of the contract. At the maturity of the contract, A returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the start of the contract.
While the structure of cross-currency basis swaps differs from FX swaps, the former basically serve the same economic purpose as the latter, except for the exchange of floating rates during the contract term.
There are two main types of cross currency swaps: floating-for-floating and fixed-for-floating.
In a floating-for-floating cross currency swap, the interest rate on both legs are floating rates. Such swaps are also called cross currency basis swap. Floating-for-floating swaps are commonly used for major currency pairs, such as EUR/USD and USD/JPY.
In a fixed-for-floating cross currency swap, the interest rate on one leg is floating, and the interest rate on the other leg is fixed. Such swaps are usually used for a minor currency against USD.
In a regular cross currency, the notional amounts of both legs are constant during the life of the swap. However, in a mark-to-market cross currency swap, the notional amount of one of the legs is subject to adjustment while the notional amount of the other leg remains constant. The mark-to-market variation is paid or received.
Non-deliverable CCS, usually abbreviated as NDCCS or simply NDS, are very similar to a regular CCS, 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 thinly traded, subject to exchange restrictions, or even non-convertible.
It is well recognized 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.
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.
- ^ "Cross currency interest rate swap". Glossary. ISDA. http://www2.isda.org/functional-areas/research/Glossary/.
- ^ "Report on global foreign exchange market activity in 2010". Bank for International Settlements. http://www.bis.org/publ/rpfxf10t.pdf.
- ^ "Cross-Currency Swap". Investopedia. http://www.investopedia.com/terms/c/cross-currency-swap.asp.
- ^ "The basic mechanics of FX swaps and cross-currency basis swaps". BIS Quarterly Review, March 2008. Bank for International Settlements. http://www.bis.org/publ/qtrpdf/r_qt0803z.htm.
- ^ "Mark-to-market Currency Swaps". http://www.derivativengine.com/mtm-cross-currency-swap.html.
- ^ "Non-deliverable Swap (NDS)". http://www.amex.com/servlet/AmexFnDictionary?pageid=display&titleid=4258.
- ^ "Interest Rate Parity, Money Market Basis Swaps, and Cross-Currency Basis Swaps". Lehman Brothers. http://www.aleablog.com/a/BasisSwaps.pdf.
- ^ "Actual factors to determine cross-currency basis swaps". Development Bank of Japan. http://mpra.ub.uni-muenchen.de/16425/1/MPRA_paper_16425.pdf.
- ^ a b 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. http://ssrn.com/abstract=1440633.
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