~/getmedia/fbdf02b1-4fa2-42af-bbad-7f789e463bc0/P-swapy.png

Swaps: FX Swap vs. Cross-Currency Swaps

Swaps are derivative contracts serving for the purpose of exchanging financial instruments. through which two parties exchange financial instruments. Such instruments can comprise of different values, however, the mostly popular is the exchange of cash when both parties agree on certain notional principal. In practice, banks do not change the principal.

Each of the cash flows has a so-called swap leg. Often, one leg comprises of a fixed cash flows, while the other leg is somehow variable, therefore it’s moving according to some interest rate, fx rate or any other indices, etc.

Interest rate swaps (IRS)

This is the most frequently used swap type on the interbank market. It’s not a business of any retail traders, nor they can’t be found on any exchanges. This is a derivative for an over-the-counter market (OTC), where banks (or any other financial institutions) exchange currencies.
 

Calculation of an IRS:

Bank A has issued a 5-yr bond with a variable annual interest rate according to the LIBOR rate + 1.3% (130 basis points). Bank A makes an agreement with the Bank B, expressing its will to pay LIBOR + 1.3% for $1 million for 5 years to the Bank A. In exchange, Bank A pays the fixed annual rate of 5% on a notional value of $1 million for the same 5 years. Let’s imagine the LIBOR stays at 1.5%.

In the event the rate rises over the next 5 years, Bank A benefits from such deal.

In the event LIBOR rises 0.75% p.a., Bank A pays $215,000 to bond holders

Year 2 = 1.5% + 0.75% = 2.25%
Year 3 = 2.25% + 0.75% = 3.0%
Year 4 = 3.0% + 0.75% = 3.75%
Year 5 = 3.75% + 0.75% = 4.5%
$215,000 = $1,000,000 x [(5 x 0.013) + 0.015 + 0.0225 + 0.03 + 0.0375 + 0.045]

This means that the Bank A pays $75,000 more to its bond holders as if the rate stayed the same (so it would pay only $140,000 if LIBOR had remained unchanged at 1.5%:

140 000 $ = 1 000 000 $ x 5 x (0,013 + 0,015)

Bank A pays Bank B $250,000:

250 000 $ = 1 000 000 $ x 5 x 0,05

Bank A receives $215,000 from the Bank B. Therefore, its net loss on the swap comes to $250,000 - $215,000 = $35,000.

FX swaps

An FX swap is another kind of agreement between two banks, exchanging one currency for another (so the EU-based Bank A lends EUR to the Bank B, while the U.S.-based Bank B lends U.S. dollars to the Bank A). In this case, the collateral for meeting its obligation is the amount to be repaid by one party to another.

Such repayment depends on the exchange rate, so the development is clear since the beginning. According to the most frequent situation for FX swaps, the picture from the Bank for International Settlements (BIS) depicts the exchange of EUR for USD through swap. The Bank A borrows USD (X·S USD) from the Bank B while lending the EUR (X EUR) to the Bank B (S means the FX spot rate). After the expiration (if not prolonged), the Bank A is obliged to return USD (X·F USD) to the Bank B, while the Bank B must return EUR (X EUR) to the Bank A (F means the FX forward rate since the start).

 

FX swaps are popular on the interbank market as they allow the banks to reach to foreign currencies easily (could apply to exporting/importing companies as well). Thanks to its popularity on the OTC market, their maturities have been often prolonged for more than 1 year, however the banks are always looking for further possibilities and derivatives as they need foreign cash flows as well. Good example is the swaption (option giving the right to the user to open a swap at certain time for the underlying asset).

✕
Fig. 1: System of FX swaps – source: BIS

Cross-Currency Swaps

Cross-currency swaps are used less frequently, however, they play an important role on the interbank OTC market.

Here, the banks borrow on currency, while lending another currency at the same time to the bank they borrowed from. The system is little upgraded from the FX swaps, albeit many traders tend to mix these two swap types.

Here, the EU-based Bank A borrows USD (X·S USD) from the Bank B, while providing it EUR (X EUR) as in case of FX swaps. Nevertheless, here the Bank A receives EUR 3M Libor+ α from the Bank B, while the Bank A pays USD 3M Libor to the Bank B every quarter (3M or Q). The α is the price of the basis swap, agreed between the parties at the beginning.

After the expiry date, the Bank A is obliged to return USD (X·S USD) to the Bank B, where S is the spot rate at the conclusion of this agreement. At the same time, the Bank B must return EUR (X EUR) to the Bank A.

Cross-currency swaps serve for the same purpose on the interbank market, however, the banks/institutions tend to take the rates (their change) into account, mainly during the volatile periods of time.

Here, due to their nature or rate change taken into account, the maturity is much longer as in case of the FX swaps as the change of rates comes much slower as in case of the exchange rate. They are often concluded from 1 to 30 years in maturity.