What Is the Purpose of a Cross-Currency Trade?
Nov 07, 2023 By Triston Martin

Over-the-counter (OTC) derivatives, such as cross-currency swaps, are agreements between two parties to exchange interest and principal payments denominated in two distinct currencies. In cross-currency trade, interest and principal in one currency are swapped for principal and interest in another.


Throughout the term of the contract, interest is paid at predetermined intervals. Interest rates on cross-currency swaps might be variable, fixed, or a combination of the two. The cross-currency exchange must not be disclosed on a company's balance sheet because the two parties are just exchanging money.


What Is the Process of a Currency Exchange?


Swapping currencies is based on the relative benefits of borrowing different currencies. Borrowers can save money by lending their cash, but they will pay more if they borrow in another country's currency. As a result, the cross currency swap works by locating a counterparty in another nation who can borrow at a more favourable rate to their own country.


Debt obligations are exchanged as soon as a party borrows at their domestic rate. In borrowing C$, Party A has the edge over Party B, but Party A also wants to borrow dollars. Contrarily, Party B can borrow $ easier than A, but they'd like to borrow C$ instead. Both parties can benefit from better exchange rates if they engage in a cross-currency swap.


Swap Principal



Exchange rates used at the commencement of a cross-currency agreement are often utilized again at the conclusion. There is an exchange rate of GBP/USD of 1.34 in the case of a swap in which business A gives firm B £10 million for $13.4 million. This means that at the end of a 10-year agreement, both firms will swap an equal amount of money back to each other. The market's exchange rate may have shifted dramatically in ten years, resulting in potential costs or rewards.


However, businesses often use these instruments to hedge or lock in rates or sums of money rather than speculate. The notional loan amounts may also be marked-to-market by the firms. Because of currency fluctuations, tiny sums of money are exchanged between the parties to make up for it. Marked-to-market loan values remain unchanged as a result of this practice.


Interest-Exchange Relationships


A cross-currency swap can be a fixed rate, a variable rate, or one party paying a set rate while the other produces a floating rate. Because these items are available over-the-counter, the two parties involved have the freedom to design them however they see fit. Quarterly interest payments are the norm. Due to the different currencies involved, interest payments are often handled in cash and not tallied. The amount each corporation owes is paid in the money it is owed on payment dates.


Swap Bank


Finding a foreign counterparty that requires the same amount and level of maturity is quite difficult. Since they help you discover the right counterparty, simplify the exchange of cash flows, and bear some risks, an intermediate swap bank is almost always present. Swap banks, on the other hand, charge a fee for the services they provide. The parties to the swap would have no reason to enter the trade if the charge were more than the quality spread discrepancy.


Swaps in Currencies Have Their Uses


The three most common ways currency swaps are employed as follows.

There are several ways in which currency swaps can be used. Back-to-back loans allow you to obtain the greatest exchange rate for any currency and convert it back to the one you want. Foreign exchange rate swings are another risk that may be mitigated through currency swaps.

This reduces the danger of substantial currency price movements that might significantly impact profits/costs on the components of a company's operations that are exposed to overseas markets.

Finally, governments can employ currency swaps to protect themselves against a financial catastrophe. A currency swap allows a country to borrow money from another country by exchanging it for its currency.


Example of a Currency Exchange


Companies in two separate countries often employ currency swaps to exchange loan amounts. Neither of them would have gotten a better deal if they had tried to secure a loan in a foreign nation on their own; they obtained the money they needed, but in the currency they wanted.

General Electric and Hitachi might undertake a currency swap to obtain Japanese yen and U.S. dollars (USD). This means that a yen loan from an American firm would be more expensive than if the American company went straight to Japan's debt market and vice versa for the Japanese company in America.

Assume that General Electric needs a sum of a hundred million dollars. The Japanese firm is in desperate need of $1,150,000. That would imply a USD/JPY rate of 90.9 if they agreed to the transaction.