Swaps are a very common type of derivative contract in our country. Derivatives are financial contracts whose value depends on the underlying instruments, such as equities, commodities, currencies, or other financial assets.
There are different types of swaps, such as commodity swaps, interest rate swaps, currency swaps, debt-equity swaps, total return swaps, and credit default swaps (CDS). But, in this blog, we will explore the details of currency swaps which are also referred to as cross-currency swaps.
What is a “Cross Currency Swap”?
A cross currency swap can be defined as an agreement between two parties to trade the principal amount and interest in one currency for the principal amount and interest in another currency. Usually, the exchange of money takes place at a fixed date at a predetermined exchange rate. The exchange rate for a cross-currency swap can either be a floating rate or a fixed rate.
Though cross-currency swaps are over-the-counter financial products, the market regulator SEBI (Securities and Exchange Board of India) has allowed cross-currency derivatives to be traded on stock exchanges since February 2018.
How does a cross currency swap work?
Let us understand how a cross-currency swap works with an example:
There is a Europe-based company with headquarters in London. It wishes to expand its business into India. Similarly, an Indian company with headquarters in Bangalore wishes to enter the European financial market.
In all probability, both of these companies will face a similar challenge. Usually, financial institutions offer better loan terms and conditions to domestic companies.
Let us discuss the options that these two companies can consider to address their funding needs:
- The Indian and European companies may be offered loans at a much higher interest rate. In other words, banks in Europe might offer loans to the Indian company while Indian banks will offer loans to the European company. But, the interest rates will be very high.
- The second option would be to avail loans from international banks which will also charge high interest rates.
- The third option would require entering into a cross-currency swap deal. If the loan amount that both of these companies would require is similar, then they can get into an agreement that would be profitable for both parties. In this case, the Europe-based company would borrow money from a European bank, while the Indian company would approach a reputable Indian bank to avail a loan.
Both companies would then proceed to use swaps on their loans to pay each other’s interest. In the event of differences in interest rates between these two regions, the companies will have to come up with an alternative way to address their credit obligations.
- Companies can also issue bonds at underlying rates to engage in cross-currency swaps. These bonds are sent to a bank which will exchange the bonds with one another.
- Now, let us imagine a situation where both companies possess each other’s assets. In this situation, the interest from the European company will be delivered to the Indian company through the services of a swap bank. The same bank will facilitate the delivery of the interest from the Indian company to the European company.
On the date of maturity, both these companies will pay the principal amount to the bank. In return, they will receive the original principal amount.
Procedure of a cross currency swap
Discussed below is the entire procedure of a cross-currency swap:
- Exchange of principal amount
When an agreement for a cross-currency swap takes place, the parties involved exchange the principal amount at a predetermined interest rate that depends on the spot exchange rate. The counterparties may also use a forward rate, which is decided before the date of a swap initiation.
While the initial exchange can take place either actually or on a notional basis, its main aim is to decide on a principal amount. It helps in the easier calculation of interest payments and the principal amount, which will be re-exchanged with a swap.
- Exchange of interest payment
Both counterparties enter into a contractual agreement to exchange currencies. After the counterparties establish the principal amount, they exchange interest payments. The type of cross-currency swap can either be fixed, floating, or a combination of both types.
- Re-exchange of principal upon maturity
Finally, the counterparties exchange the principal amount that was decided when setting up the contractual agreement. Note that during a cross-currency swap, counterparties can exchange the principal amount either at the onset of a contractual agreement or at the end of the currency swap contract. The exchange can happen at the beginning and end of the contract as well.
The points mentioned above are usually followed when two parties decide to enter into a cross-currency swap agreement. But steps may differ when two parties decide to opt for a specific type of currency swap.
Types of cross currency swaps
- Fixed for Fixed currency swaps
When both parties availing loans agree to exchange currencies at a fixed interest rate, it is known as a fixed for fixed currency swap. Companies can use this type of cross-currency derivative when another country offers cheaper interest rates.
This type of cross-currency swap helps companies benefit from the low-interest rates offered by their respective countries.
- Fixed for Floating currency swaps
It is a contractual agreement between two parties where one party pays the interest payment based on a fixed interest rate and receives interest payments from the counterparty based on a floating interest rate.
It enables parties involved in the agreement to make use of assets and liabilities that are quite sensitive to interest rate movements.
- Floating for Floating currency swaps
This is an agreement between two parties where they pay and receive interest rates depending on floating interest rates. Parties can use this type of cross-currency swap to reduce the risks associated with two different indices that are greatly fluctuating in value.
Benefits of cross currency swaps
- Offers financial flexibility
In the financial market, traders consider cross-currency swaps as an option that offers a lot of financial flexibility. It enables companies investing in developing markets to lower their exposure to currency fluctuations.
This is because cross-currency swaps enable the denomination of funds/loans from one currency to another. On the other hand, foreign companies get the opportunity to invest in domestic markets at a much lower risk through the option of currency swaps.
- Minimal risk for foreign transactions
A major advantage is that the risk involved with cross-currency deals is very minimal. The high liquidity of swaps also makes financial transactions easier for companies. This helps parties in two ways. Firstly, parties can negotiate for the early termination of a swap deal. Secondly, it provides the counterparties with the freedom to opt for a settlement at any point during the contract period.
- Helps to earn from market dynamics
Cross-currency swaps are particularly beneficial for international transactions because the parties involved can benefit immensely from a change in interest rates and cross-currency dynamics.
- Certainty in volatility
This derivative enables the counterparties to decide the interest rate and currency exchange rate. As a result, the parties can manage volatility in the financial market to their advantage. It helps them make more informed business decisions and formulate strategies with more certainty.
- Helps with debt management
Companies can opt for cross-currency swaps for their debt management. Every business has to mandatorily engage in debt management to better manage its liabilities and financial assets to achieve its financial goals. Cross currency swaps provide access to loans with lower interest rates that are not present in the domestic economy.
- Provides an opportunity to increase RoI
Another benefit offered by cross-currency swaps is increased return on investment (RoI) by decreasing forex exposure. This is because it helps them free up funds that would otherwise have been allocated to the forex market. Companies can use this freed-up capital to invest in other avenues for further growing their business.
Disadvantages of cross currency swaps
- Exposure to credit risk
Credit risk is an important limitation of cross-currency swaps because there remains the possibility of the counterparties defaulting on their payment of principal and interest.
- Possibility of fall in the domestic currency’s value
If the government of a country increases its foreign debt to support the value of its currency, it may lead to a massive fall in the value of the domestic currency. The possibility of governmental intervention in exchange markets is another important factor to consider.
- High expenses
Cross currency swaps involve multiple costs that are not present in other financing options. As a result, it is difficult to make a profit.
Important factors to consider about cross currency swaps
Here are some of the important factors that you need to consider before opting for a cross-currency swap:
- Enter into a cross-currency swap agreement only after proper analysis because it is a long-term agreement.
- You stand the risk of losing money if the principal amount of your currency swap increases and you need more capital.
- Getting into a cross-currency swap agreement with a like-minded partner can be difficult.
- You need to make sure that all the paperwork and the correct procedures are followed to avoid legal disputes.
- Do not forget that the market is unpredictable.
Cross-currency swaps enable parties living in different countries to get funding and exposure to different currency markets. Some of its important benefits include financial flexibility and the ability to improve one’s debt situation. Before entering into a cross-currency swap agreement, it is essential to do a thorough analysis because these transactions are not devoid of risks.
Frequently Asked Questions
- Who regulates swaps in India?
In India, the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) regulate swaps. Generally, the RBI is responsible for regulating foreign currency derivatives, interest rate derivatives, and credit derivatives.
- Why do countries opt for currency swaps?
Cross-currency swaps enable companies in a country to avail loans at a lower interest rate than in foreign markets. The country receiving a loan finds it easier to maintain its foreign reserves.
- How are the exchange rates for currency swaps determined?
The exchange rates of currencies change every day, which may cause repayment problems. So, the exchange rate is decided during the signing of the agreement.
- How to trade cross-currency derivatives?
You can trade cross-currency derivatives by taking up positions through futures or cross-currency options. Remember that there might be unlimited gains and losses in the trading of futures. But, options will generate an asymmetric pay-off.
Darshan is an up-and-coming Investment analyst making headway in the field of capital markets. He has completed his Chartered Accountancy and CFA Level 1 exam. He is currently working as a Credit Associate in Wint Wealth.