Cross-currency swaps are a type of over-the-counter (OTC) derivative where two parties agree to exchange interest payments and principal amounts in different currencies. In this arrangement, one party’s interest payments and principal in one currency are traded for those in another currency. These interest payments are typically exchanged at regular intervals throughout the duration of the swap. Cross-currency swaps offer a lot of flexibility, allowing for fixed, variable, or a mix of interest rates.
Because the two parties are simply swapping funds, these swaps don’t need to be recorded on a company’s balance sheet.
The Example of Cross-Currency Swap
One popular type of currency swap involves companies from different countries exchanging loan amounts. This arrangement allows both companies to secure the loans they need in their preferred currencies, often with better terms than they would achieve by seeking loans independently in a foreign market.
Take, for instance, General Electric, a U.S. company that wants to obtain Japanese yen, and Hitachi, a Japanese firm looking to acquire U.S. dollars (USD). These two could engage in a swap. Hitachi likely has better access to Japanese debt markets, allowing it to secure a yen loan on more favorable terms than General Electric could if it approached the Japanese market directly, and the same goes for Hitachi in the U.S.
Let’s say General Electric needs ¥100 million, while Hitachi requires $1.1 million. If they agree to swap these amounts, it suggests an exchange rate of 90.9 USD/JPY.
General Electric would pay 1% interest on the ¥100 million loan, with a floating rate, meaning their payments will vary if interest rates change.
On the other hand, Hitachi would pay 3.5% on the $1.1 million loan, also with a floating rate. They could choose to fix the interest rates if they prefer.
They decide to use the 3-month LIBOR rates as their interest rate benchmarks, with interest payments made quarterly. The principal amounts will be repaid in 10 years at the exchange rate established at the time of the swap.
The difference in interest rates reflects the economic conditions in each country. At the time of the swap, interest rates in Japan are approximately 2.5% lower than those in the U.S.
On the trade date, both companies will exchange the notional loan amounts.
Over the next decade, each company will pay interest to the other. For example, General Electric will pay 1% on ¥100 million quarterly, assuming interest rates remain stable. This amounts to ¥1 million annually or ¥250,000 each quarter.
When the agreement wraps up, they’ll exchange the currencies back at the same rate they started with. This means they won’t face any exchange rate risk, but they might miss out on potential gains or incur losses. For instance, if the USD/JPY rate jumps to 100 right after the two companies enter the cross-currency swap, the dollar’s value has risen while the yen’s has dropped. If General Electric had waited a little longer, they could have gotten ¥100 million by only trading $1.0 million instead of $1.1 million. However, companies usually don’t enter these agreements to speculate; they do it to secure exchange rates for specific timeframes.