Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.

Cross currency swap

A cross currency basis swap is a contractual agreement between two parties to exchange interest payments and principal, in the form of borrowed or loaned money, in two separate currencies. It is essentially an interest-rate derivative (IRD), meaning that its value is based on underlying interest-bearing assets, such as options and futures.

Cross currency swaps are a type of over-the-counter product that exist within the foreign exchange market, where investors will exchange different currency pairs through a forex trading platform. As they are not traded on a centralised exchange, they can be customised at any point in the contract. For example, traders can delay payments, reverse fixed dates and change notional amounts for each currency.

See inside our platform

Get tight spreads, no hidden fees and access to 9,300+ instruments.

What is a cross currency swap?

The way the swap agreement works is this: the first party borrows a specific amount of foreign currency from the counterparty at the current exchange rate. In turn, it lends a corresponding amount to the counterparty of its own currency. Both parties pay interest to each other throughout the duration of the contract in the currencies that they both received. Interest rates are calculated according to each currency index and can be fixed, variable or both. Currencies traded usually include the major forex pairs, such as USD/EUR and USD/JPY. The counterparties involved in a cross currency swap are usually institutional investors.

There are three principal objectives for trading cross currency swaps, as follows:

  1. To hedge against fluctuations in foreign exchange rates. This is particularly useful for institutional investors, as currency hedging helps to reduce the risk of exposure to currency price movements.
  2. To ensure cheaper debt. By using back-to-back loans, investors borrow currency at the best available rate and then exchange it back for debt in their desired currency.
  3. To be used in times of financial crisis as a defence. Cross currency basis swaps allow countries to lend their own currencies to other countries that are in a state of liquidity crisis, as a loan to be paid back in interest payments.
Join a trading community committed to your success

Cross currency swap hedge

As discussed, cross currency swaps can be used as a hedging strategy within the forex market. If a company makes business transactions on an international level, it may experience some form of currency risk. This is when exchange rates change before converting foreign currency back into your desired currency. Likewise, if an investor’s trading portfolio contains positions weighted in other foreign currencies, then it is exposed to currency risk. In particularly volatile economic or political periods, exchange rates between currencies can fluctuate and this may result in a decline in value of the overall portfolio. This is where cross currency swaps come in handy for currency hedging​.

Example of a cross currency swap

Below is an example of a cross currency basis swap between a Japanese counterparty and an American counterparty, with the corresponding forex pair USD/JPY​.

Let’s say that the Japanese party is looking to borrow US$100 million and, in turn, lends ¥50 million to the American party. This is a spot exchange rate of US$2 per JPY, which is indexed to the London Inter-bank Offered Rate (LIBOR) when the contract begins.

Throughout the duration of the contract, the Japanese party receives interest payments in JPY from its counterparty, plus a basis swap price. Interest payments are usually paid on a quarterly basis. In turn, it pays the American counterparty the notional amount in USD at the Libor interest rate. Both parties can agree to keep the interest rates fixed, or if they prefer, allow interest rates to fluctuate based on the economic conditions of each country.

When the contract comes to an end, the Japanese company will pay the full principal amount of US$100 million back to the American company, and will receive the full exchange price back of ¥50 million.

What is the difference between a cross currency swap and an FX swap?

Although they share similarities with other products, such as FX swaps and FX forwards, there are notable differences that set cross currency trades aside.

Cross currency basis swaps are currency derivatives, largely focused on interest payments. On the other hand, forex swaps do not exchange any interest between parties, and the amount of principal exchanged at the end of a contract is of a different value to the beginning. Both forex instruments are used by large corporations and institutional investors. Cross currency swaps can be seen as long-term instruments, as their contracts can often span for decades, whereas investors can trade FX swaps for as little as a day, making them more suitable for short-term investing. As forex swaps do not deal with interest payments, they cannot be used to offset interest-rate risks.

Cross currency swap vs FX forward

Cross currency swaps work in a similar way to a forward contract​. This is an agreement between a buyer and seller to trade a financial instrument at a specified price at some point in the future. Forward contracts are a type of derivative product, similar to futures and options​. However, forward trading also does not deal with interest rate risk, and can only be used to hedge the risk of changing foreign exchange rates and the principal repayment of a loan. Therefore, forwards and FX futures do not cover all aspects of currency risk, which explains the attraction to investors of a cross currency swap.

How to value a cross currency swap

Cross currency swaps are generally difficult to value, due to the different funding costs for each currency. Traditional trading rules would assume that the funding cost in each currency is equal to its floating rate, therefore giving a zero cross currency spread​. However, investors have differing levels of access to different currencies around the world, and therefore, funding costs are not calculated the same as in the LIBOR, where we tend to calculate interest rates for UK trading.

Investors have found a way to work around this. They can now select one currency as the funding currency and select one curve in this currency to be the discount curve. Future cash flows are then discounted at the market interest rate that is applicable at the time of valuation. The sum of the cash flows from the foreign currency are swapped into the funding currency at its spot price, and then discounted afterwards. Cross currency swaps differ to other interest-rate derivatives in that there will always be an exchange of a notional or face value amount.

Summary

Cross currency basis swaps can be used effectively to hedge currency risk within the forex market. They may not be particularly suitable for short-term traders, who tend to prefer a simpler instrument such as an FX swap. However, for institutional investors and large corporations who deal with foreign currency trading on a frequent and international scale, this may be the perfect solution for forex traders.

Powerful trading on the go

Seamlessly open and close trades, track your progress and set up alerts

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

Join over 90,000 other committed traders

1

Apply for a live account

Complete our straightforward application form and verify your account

2

Fund your account

Deposit easily via debit card, bank transfer or PayPal

3

Find and trade

One touch, instant trading available on 9,300+ instruments