Cross-currency swap explained: definition, calculation and example

A cross-currency swap is a type of FX instrument used by institutions and banks to gain better access to foreign debt markets. Find out more about this swap and why it’s used.

What are cross-currency swaps?

Cross-currency swaps are agreements between two parties to exchange interest payments and principals denominated in different currencies. They’re used to access more advantageous loans and lock in an exchange rate, rather than speculate on the assets in question.

So, for example, the interest and principal of an asset denominated in British pounds would be exchanged for the interest and principal of an asset denominated in US dollars.

Usually, cross-currency swap transactions take place via an intermediary – such as a swap bank – given how difficult it is to personally find someone with the same needs.

What is a cross-currency swap used for?

A cross-currency swap is primarily used as a way of purchasing less expensive debt. It allows companies to get the best rate of a foreign currency and exchange it back to their domestic currency at a desirable rate with back-to-back loans.

These types of transactions are particularly common among companies that have foreign operations, as a domestic individual or company will have better access to the nation’s debt markets and get more favourable terms on loans. So, taking domestic loans, and then swapping them with a foreign counterparty can work out better for both parties.

Cross-currency swaps are also used to hedge the potential for adverse foreign exchange fluctuations and reduce the potential impact of currency rate risk for companies that have foreign exposure.

How do cross-currency swaps work?

A cross-currency swap agreement works by the first party borrowing a specific amount of foreign currency from a second party at the current exchange rate. At the same time, the first party lends a corresponding amount of its domestic currency to the counterparty. Both parties pay interest to each other throughout the duration of the contract in the currencies that they both received.

A cross-currency swap can work in different ways, as these products are over-the-counter, they can be customised in any way the two parties want. Typically, there are three types of swaps in which:

1. Both parties pay a fixed rate
2. Both parties pay a floating rate
3. One party pays a floating rate while the other pays a fixed rate

Interest payments are typically calculated quarterly.

To help demonstrate how cross-currency swaps work, let’s look at an example.

Cross-currency basis swap example

British company A wants to buy dollars, and US company B wants to buy pounds, so they decide to perform a swap.

Company A takes out a loan in the UK for £20 million on a fixed rate of 2.5%, and Company B takes out a loan in the US for $23.5 million on a fixed rate of 1%. They then exchange the terms of the contract with each other, at an implied GBP/USD exchange rate of 1.02.

To do so, the companies take part in a cross-currency basis swap – customising the terms to their specific needs.

The agreement is for a duration of 10 years. Meaning that at the end of the 10 years, the companies will exchange the same amounts back to each other, at the same exchange rate as the original transaction.

On the trade expiration date, the two companies will exchange the loan amounts back to each other at the original 1.02 rate. As the GBP/USD rate after 10 years is likely to look extremely different than at the current moment, the transaction could provide gains or losses to each party.  

Throughout the 10 years, each party will pay the interest in the currency they received – so Company A will pay a quarterly 1% on the $23.5 million loan to the US firm, and Company B will pay 2.5% to the UK firm on their £20,000 loan.

How to price cross-currency swaps

Pricing cross-currency swaps is quite difficult, as there can be a range of different factors that come into play. For example, in the UK, interest rate costs are calculated using the SONIA overnight rate, whereas in the US it would be SOFR.

But in theory, the cash flows should be as near to identical as possible to ensure that the transaction has little market value for either firm (it doesn’t make one more money than the other).

Usually, a basis spread is incorporated into the transaction. This reflects the demand for one currency relative to the other. So, one way to calculate the potential gain from a cross-currency swap is by looking at the spread differential.

Cross-currency swap spread

The calculation for the cross-currency swap spread differential is:

Quality spread differential = rate differential A – rate differential B

Revisiting our previous example, let’s imagine the UK company A could get a rate of 1.25% for a loan of $23.5 million in the US, but 1% if they accessed the loan via a US company. The rate differential for A would be 0.25%.

Meanwhile, US company B could get a rate of 3.5% on a £20,000 loan themselves, but 2.5% if they entered the swap with a UK counterparty. That would be a rate differential of 1%.

So, our cross-currency swap spread would be calculated as:

QSD = $(1.25%-1%) - £(3.5%-2.5) = +0.75%

The parties each enjoy a preferential rate, but the US company benefits more from the agreement – this wouldn’t necessarily be unusual given the US dollar typically comes at a funding premium. But under contract negotiation, the companies could adjust their interest rates to balance the market value.

Risks of cross-currency swap

The greatest risk of a cross-currency swap is counterparty default risk. This is the chance that either party involved in the transaction can no longer meet their obligations – whether that’s paying interest in a quarter or failing to repay their entire loan at expiry.

This risk is usually managed by the intermediary – such as a swap bank – who will assess the credit of each party before the transaction takes place. In some instances, a less trustworthy party might even have to put up collateral in case of default.

Cross-currency swap vs FX swap

An FX swap is another type of agreement between two parties that involves exchanging one currency for another. For example, party A borrows US dollars from party B, while simultaneously lending euros to party B. After the expiration, party A will return the US dollars to party B and receive their euros back.

Both instruments are used by large corporations and institutional investors. But the difference between an FX swap and a cross-currency swap lies in the fact that the exchange rate isn’t fixed. So, when participants in an FX swap get to expiry, the value of the transaction could be vastly different to when they entered the agreement. Whereas a cross-currency swap fixes the exchange rate.

Cross-currency basis swaps also pay interest throughout the term of the contract, while forex swaps do not exchange interest between parties.

That’s why cross-currency swaps are considered longer-term instruments, as participants are comfortable entering contracts that can span for decades because they get a fixed exchange rate and the option of interest payments. Whereas FX swaps often take place over much shorter periods, even as little as a day.