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### Cross Currency Swaps

Currency swap differs from interest rate swap in three features, as follows.
1. The two interest amounts exchanged under the swap are denominated in different currencies.
2. Apart from the interest exchange, it has an additional exchange which is the capital gains or losses in the exchange rate between the two currencies.
3. The exchange of principal may be actual or notional.
Because the currency of the amount is different, all combinations of fixed-floating exchanges are possible, as shown below, each of which is given a specific name.

Nature of exchange Name of the swap
Fixed-for-floating Cross currency swap
Floating-for-floating Cross currency basis swap
Fixed-for-fixed Cross currency coupon swap
Notice that the fixed-for-fixed swap is not possible in interest rate swap. It is only possible in currency swap.

The above additional features bring about the following changes in the quotation of the swaps.
• Since there are two quoted currencies, the swap must mention the exchange rate. The exchange rate usually follows the FX quotes convention i.e. the base currency is quoted first and the variable currency is quoted next. For example, USD/INR or EUR/USD.
• The notional/principal must be equal. But since there are two currencies involved, two notionals or principals at the agreed exchange rate must be mentioned. For example, at an exchange rate of EUR/USD = 1.30, the notional would be 1 million EUR and 1.3 million USD.
• The interest amounts are exchanged every year and, usually, computed at 2% on EUR notional/principal and 3% on USD notional/principal.

Let's take an example to understand currency swap.

In the above example, company ABC is based out of London which raises pound denominated loan from the London market. It has to pay a fixed pound interest rate on this loan. It intends to invest the money in the US market. To do that it needs dollars. It goes to the FX market and converts its pounds to dollars at an exchange rate of say GBP/USD = 1.2. It takes the dollars and invests them into the US market on which it will receive returns in US dollars. At this juncture, it is exposed to exchange risk on interest and principal arising from the changes in exchange rate between GBP and USD.

The company can hedge this risk by entering into a swap with a swap dealer. It can, under the swap agreement, agree to receive fixed interest in GBP and pay fixed interest in USD (the money that it receives in USD from its US investments). By doing so, the company can use the GBP interest that it receives from the swap dealer to pay the GBP interest obligation that it owes to the London bank.

In the above arrangement, the company will have to make sure that the type of GBP interest rate that it receives in the swap should be the same as the GBP interest rate that it pays on its loan - i.e. both are fixed or both are floating.

If the company has converted GBP principal into USD principal in the forex market, then there should not be any exchange of principal, because the company now does not have EUR principal to be exchanged under the swap. If the company has not converted GBP into USD in the forex market, then the company will exchange EUR principal for USD principal in the swap. Accordingly, both versions (i.e. principal exchange can be notional or actual) are possible. Currency swap is a risk management too, while the currency conversion is cash management. When the principal amounts are not exchanged, currency swap is used for risk management. When they are exchanged, currency swap is used for both risk and cash management.

There could be two reasons for separating risk and cash management functions (and therefore not exchanging principal in currency swap). First, the loan and currency swap are contracted at different time. Cash management is more pressing than risk management and therefore currency conversion is executed immediately in forex market, followed by hedging through currency swap. Second, the company opts to execute the currency conversion and currency swap with different institutions because of the competitive quote for products.

Let's us now consider the exchange of capital gains/loss, which is linked to whether the principal exchange is notional or actual.

If Principal exchange is notional
Since the principal is not exchanged at the beginning, the re-exchange at the end does not arise. The company has to buy GBP in the spot forex market and repay the loan. If the market now is 1.22, there will be a loss of GBP 16,393.45 (as originally, the GBP 1 million was converted into USD 1.2 million but on reconversion it could only get back on GBP 983,606.55). The currency swap, being a currency risk management tool, will compensate the company for this loss. Similarly, if the spot forex price is 1.18, the company would gain GBP 16,949.15 (as originally, the GBP 1 million was converted into USD 1.2 million but on reconversion it could get back GBP 10,16,949.15). However, this profit would be passed to the currency swap counterparty. In all cases, the company having hedged the currency risk through currency swap, the cost of GBP purchase to the company should be exactly the same as the sale price at the beginning, and any gain/loss will be to the account of the currency swap counterparty, not the company's.

If Principal is actual
The exchange of capital gain/loss does not arise in this case. The company exchanges the principal amounts at the spot forex rates prevailing at the beginning, and the re-exchange will be exactly at the same rate. It is like you take a mortgage loan for one million against home. For the repayment, you pay exactly the same principal amount of one million regarless of what the current market value of the home now is.

The following is the summary of exchange of principal amounts and capital gains/loss in a currency swap.
1. Exchange of principal is notional
1. Notional amounts quantified at the spot forex rate prevailing at the beginning.
2. Interest amounts are periodically exchanged during swap term, based on the notional amount.
3. At the end of the swap term, the difference between the currency spot forex rate and that at the beginning, which is the capital gain/loss, is passed on to the currency swap counterparty so that there is neither gain nor loss to the hedger.

2. Exchange of principal is actual
1. Principal amounts exchanged at the spot forex rate prevailing at the beginning.
2. Interest amounts are periodically exchanged during swap term, based on the principal amount.
3. At the end of the swap term, the principal amounts are re-exchanged at the same rate as they were exchanged at the beginning. In other words, the computation of capital gain/loss does not arise.

Market to Market (MtM) in a Currency Swap
Interest rate swap changes in value because of changes in interest rate. Currency swap changes its value because of change in interest rate and changes in spot forex rate. The changes in interest rates are about 1% ~ 2% a year, but the changes in forex price can be 15% ~ 20% a year. Therefore, if the counterparty defaults in the swap, the replacement cost of the trade with another will be higher in currency swap than in interest rate swap. To mitigate the elevated counterparty credit risk, currency swap is subjected to mark-to-market (MtM), and the MtM dates usually coincide with interest payment dates. The following example illustrates this.

Terms Details
Currency pair EUR/USD
Swap type Cross currency coupon swap
Principal/Notional EUR 1 million
Interest rates 3% for EUR and 4% for USD
Payment frequency Annual
Swap tenor 3 years

Let's assume that the following are the spot forex rates for the purposes of principal exchange and mark-to-market

Time FX Rate
Beginning 1.30
1 year 1.31
2 years 1.29
3 years 1.32

The MtM cash flows are capital gain/loss in nature, they are always exchanged regardless of whether the principal amounts are exchanged or not. There are two parties to this transaction - Party A and Party B. Party A is the buyer of this cross currency swap; Party B being the seller. The buyer of a cross currency swap is the party willing to pay the base currency in exchange for receiving the quoting currency. The currency pair is EUR/USD. Thus, Party A will pay EUR and receive USD. This can also be thought-of as a borrow-lend transaction, wherein Party A is willing to lend EUR and borrow USD.

If principal exchange is not involved, then there won't be any exchange of principal at the beginning of the trade. If principal exchange is involved, then Party A will lend EUR 1 million to Party B and simultaneously Party B will lend USD 1.3 million to Party A. The first exchange will happen at the end of the first year. The exchange will be of the interest amounts. Considering that Party A has borrowed USD, interest on USD 1.3 million @ 4% on USD is payable by him to Party B. Similarly, Party B has borrowed EUR. Interest on EUR 1 million @ 3% is payable by him to Party A. The respective interest amounts are EUR 30,000 and USD 52,000. Party A will need to pay USD 52,000 to Party B and receive EUR 30,000 from him.

Apart from the interest exchange, the capital gain/loss will need to be exchanged during MtM. The exchange rate at the beginning of the contract was 1.3. It is 1.31 at the end of first year. The EUR has appreciated against USD by USD 0.01 (or we can say that USD has depreciated against EUR). This depreciation of USD is a loss to Party A (lender of EUR). The reason is something like this: Party A has converted his EUR 1 million into USD 1.3 million (whether notionally or in real, it does not matter) at an initial exchange rate of EUR/USD = 1.3. If he were to recovert his USD 1.3 million back to EUR, then he will only get USD 9,92,366.41 at the current exchange rate of EUR/USD = 1.31. This loss of EUR 7,633.58 (or USD 10,000) needs to be compensated by the counterparty (i.e. Party B). Therefore, apart from the interest transfer, there would also be an capital gain/loss transfer of EUR 7,633.58 (or USD 10,000) by Party B to Party A. Another way to look into this problem is as follows: Party A had taken USD 1.3 million earlier, but at current spot rate of 1.3, he should have received USD 1.31 million. Therefore, the difference of USD 0.01 million is not received by Party A.

The second interest exchange will happen at the end of 2nd year. Party A has to pay to Party B interest @ 4% on USD 1.31 million for 1 year(remember: after the MtM the notional value is adjusted as per the current exchange rate. Thus, the USD notional for MtM purposes would be USD 1.31 million. Similarly, Party B will have to pay Party A interest @ 3% on EUR 1 million for 1 year. The respective interest amounts would be USD 52,400 and EUR 30,000.

Apart from the interest exchange, the capital gain/loss for the 2nd MtM would be based on the difference in FX rates. The previous FX rate was 1.31; the current FX exchange rate at the end of 2nd year is 1.29. USD has appreciated against EUR. As per the concept explained earlier, there is a gain of EUR 15,503.87 (or USD 20,000) to Party A, which is equal to the loss made by Party B. Therefore, Party A will need to pay to Party B EUR 15,503.87 (or USD 20,000).

The third and final interest exchange will happen at the end of 3rd year. Party A has to pay to Party B interest @ 4% on USD 1.29 million for 1 year (notional is as per the current exchange rate. please refer to the explanation provided above). In return, Party B has to pay to Party A interest @ 3% on EUR 1 million for 1 year. The respective interest amounts are USD 51,600 and EUR 30,000.

If principals are not exchanged then the capital gain/loss MtM would be on the difference between the current exchange rate and previous exchange rate i.e. 1.32 and 1.29. The difference is 0.03 USD. Who has to pay to whom? USD has depreciated against EUR. There is a loss of EUR 22,727.27 (or USD 30,000) to Party A. This amount will have to be paid by Party B.

If principal is exchanged then it shall be exchanged at the current exchange rate i.e. EUR/USD = 1.29. Party A will receive EUR 1 million and Party B will receive USD 1.29 million.

The following table shows the cash flows with and without exchange of principal.

With exchange of principal - In the books of Party A
Year Description FX Rate Party A - EUR Receipts Party A - EUR Payments Party A - USD Receipts Party A - USD Payments
On Effective Date Transfer of Principal 1.3 n.a. EUR 1 million USD 1.3 million n.a.
End of year 1 Interest exchange 1.31 EUR 30,000 n.a. n.a. USD 52,000
Capital gains/loss exchange n.a. n.a. USD 10,000 n.a.
End of Year 2 Interest exchange 1.29 EUR 30,000 n.a. n.a. USD 52,400
Capital gains/loss exchange n.a. n.a. n.a. USD 20,000
End of Year 3 Interest exchange 1.32 EUR 30,000 n.a. n.a. USD 51,600
Capital gains/loss exchange n.a. m.a. n.a. n.a.
Re-exchange of principal EUR 1 million n.a. n.a. USD 1.29 million
Summary Total of interest receipts EUR 90,000
Total interest payments USD 1,56,000
Total MtM paid USD 20,000
Net MtM loss paid to Party B (X) USD 10,000
USD re-exchange amount (Y) USD 1.29 million
Total principal returned (X + Y) USD 1.3 million This amount is equivalent to the original exchanged amount under the contract

Without exchange of principal - In the books of Party A
Year Description FX Rate Party A - EUR Receipts Party A - EUR Payments Party A - USD Receipts Party A - USD Payments
On Effective Date Transfer of Principal 1.3 n.a. EUR 1 million USD 1.3 million n.a.
End of year 1 Interest exchange 1.31 EUR 30,000 n.a. n.a. USD 52,000
Capital gains/loss exchange n.a. n.a. USD 10,000 n.a.
End of Year 2 Interest exchange 1.29 EUR 30,000 n.a. n.a. USD 52,400
Capital gains/loss exchange n.a. n.a. n.a. USD 20,000
End of Year 3 Interest exchange 1.32 EUR 30,000 n.a. n.a. USD 51,600
Capital gains/loss exchange n.a. m.a. USD 30,000 n.a.
Summary Total of interest receipts EUR 90,000
Total interest payments USD 1,56,000
Total MtM paid USD 20,000
Net MtM gain USD 20,000
Total loss suffered by Party B USD 20,000 This is equivalent to: if the beginning FX rate of 1.3 and end FX rate of 1.32 are considered directly

In MtM of currency swaps, the usual practice is to keep the base currency amount constant during swap term and vary the quoting currency amount, because this is how the spot forex price is quoted.

Non-Deliverable Swap (NDS)
What is NDF to conventional forward, the NDS is to conventional currency swap. In a conventional currency swap, the parties agree to:
• Periodically exchange interest payments denominated in two currencies; and
• Exchange principal amounts of two currencies at the outset; or or if principal is not exchanged, then the difference in the spot prices prevailing at the outset and at the end is settled as a single cash amount.
NDS is a currency swap that has compulsory cash-settlement for both interest payments and principal exchange. Typically, one currency is USD ("Settlement Currency") and the other an emerging market currency ("Reference Currency") which is dealt on "non-deliverable" basis but is converted into equivalent Settlement Currency amount and settled. The following are the features of NDS.

Because of non-deliverable status, principal is never exchanged at the beginning. Only the notional amounts for the two currencies are agreed, based on the spot forex rate prevailing in the fixing date attached to the swap's start date.

The interest rate for Settlement Currency is either fixed or floating, but the interest rate for the Reference Currency is fixed in almost all cases.

The periodic interest amounts in the Reference Currency are converted into equivalent Settlement Currency amount at the spot forex rate prevailing on the Fixing Date attached to the interest payment dates. With this, both interest amounts (one is a payment and the other is a receipt) are denominated in the same currency; and they are netted out and the net amount is settled. If the interest payment dates for both currencies do not coincide, then netting will not be possible, the amount converted into equivalent Settlement Currency amount is settled.

At the end of the swap term, there shall be no principal re-exchange because it was not exchanged at the inception. However, to complete the currency risk management function of NDS, the difference in the spot forex rate prevailing on the fixing date attached to the swap's start date and the spot forex rate prevailing on the fixing date attached to the swap's end date is converted into equivalent Settlement Currency amount at the spot forex rate prevailing on the fixing date attached to the swap's end date; and is settled. The currency fixing methodology is similar to that in NDF.

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First updated on 7th September 2019