Cross-Currency Swap: Definition, How It Works, Uses, and Example

The difference in interest rates is due to the economic conditions in each country. In this example, at the time the cross-currency swap is instituted the interest rates in Japan are about 2.5% lower than in the U.S.. The parties could also agree to keep the interest rates fixed if they so desire. General Electric will pay 1% on the ¥100 million loan, and the rate will be floating.

Ever since she began contributing to the site several years ago, Mary has embraced the
exciting challenge of being a SmartCapitalMind researcher and writer. Mary has a liberal arts degree from Goddard College and
spends her free time reading, cooking, and exploring the great outdoors. Swaps comprise one type of derivative, but its how to buy electroneum with usd value isn’t derived from an underlying security or asset. Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR).

  • Experience shows that FX derivatives can also be used to take open positions, including in the form of carry trades.
  • Many leveraged accounts (eg Commodity Trading Advisor funds) sell dollars in the futures market rather than in the OTC market.
  • That is, the notional amounts are not purely used as reference for the income streams to be exchanged, such as in interest rate derivatives.
  • In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day.

Interest payments are exchanged at fixed dates through the life of the contract. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company’s balance sheet. Both companies have effectively taken out a loan for the other company. Second, currency swaps can be used to hedge against foreign exchange rate fluctuations. Doing so helps institutions reduce the risk of being exposed to large moves in currency prices which could dramatically affect profits/costs on the parts of their business exposed to foreign markets. In a currency swap, the two parties agree to exchange notional amounts of currencies at an agreed-upon exchange rate and then, at a specified future date, reverse the transaction at a prearranged rate.

Despite their role, the geography of their utilisation remains opaque. And, largely because of accounting conventions, their regulatory treatment differs markedly from that of instruments that, economically, are also forms of secured debt. Both of these aspects deserve more attention than they have generally received so far. Foreign exchange swaps and cross currency swaps are very similar and are often mistaken as synonyms. The parties swap amounts of the same value in their respective currencies at the spot rate.


In particular it is a linear IRD, and one of the most liquid benchmark products spanning multiple currencies simultaneously. It has pricing associations with interest rate swaps (IRSs), foreign exchange (FX) rates, and FX swaps (FXSs). In a total return swap, the total return from an asset day trading institution is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an index. For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool of stocks.

  • 20 In some cases, the authorities finance some foreign exchange reserves by swapping domestic currency into dollars.
  • Both parties have interest rate risk because interest rates do not always move as expected.
  • IBM swapped German Deutsche marks and Swiss francs to the World Bank for U.S. dollars.
  • 7 The gross market value of these positions amounted to $1.5 trillion ($1.3 trillion for dollars) at end-2016.

The Reserve Bank of New Zealand (RBNZ) holds it policy meeting on Wednesday and is widely expected to keep rates steady at 5.5%. Yields on Australian 10-year debt hit an 11-year high of 4.61% early Tuesday, having climbed 51 basis points in just 12 sessions. Futures imply around a 36% chance of a rate rise in November and are fully priced for a move to 4.35% by May next year. A slim majority of economists polled by Reuters also tip one more rise this cycle.

They both receive the loan they want, in the currency they want, but on better terms than they could get by trying to get a loan in a foreign country on their own. They saw funding squeezes during both the global financial crisis and again in March 2020 when the COVID-19 pandemic wrought havoc that required central banks such as the U.S. LONDON, Dec 5 (Reuters) – Pension funds and other ‘non-bank’ financial firms have more than $80 trillion of hidden, off-balance sheet dollar debt in FX swaps, the Bank for International Settlements (BIS) said. One purpose of engaging in a currency swap is to procure loans in foreign currency at more favorable interest rates than might be available borrowing directly in a foreign market. The forward rate is the exchange rate on a future transaction, determined between the parties, and is usually based on the expectations of the relative appreciation/depreciation of the currencies. Expectations stem from the interest rates offered by the currencies, as demonstrated in the interest rate parity.

Global banks’ dollar funding needs and central bank swap lines

It will then deliver the £100 million to the swap bank who will pass it on to the U.S. Piper Company to finance the construction of its British distribution center. The Piper Company will issue 5-year US$150 million bonds paying 10% interest. The Piper Company will then pass the $150 million to swap bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its U.S. refinery. Commodity swaps involve the exchange of a floating commodity price, such as the Brent Crude oil spot price, for a set price over an agreed-upon period. As this example suggests, commodity swaps most commonly involve crude oil.

Assuming that the net FX position is zero, as typically encouraged by bank supervisors, we estimate the net use of swaps as the net positions in a given currency. Moreover, as mentioned before, the resulting net positions are likely to underestimate the gross debt positions, especially for dealer banks. This box explains how the accounting treatment of borrowing and lending through the FX swap and related forward market gives rise to missing debt.

In both episodes, a credit risk shock somewhere in the global economy led to a scarcity of dollar funding both inside and outside the United States. The cost of securing short-term dollars jumped as the suppliers pulled back. Banks and non-banks alike, many of them otherwise solvent, suddenly faced dollar repayment obligations when their dollar funding positions could no longer be rolled over. Every day, trillions of dollars are borrowed and lent in various currencies.

Understanding Foreign Exchange Swaps

Many deals take place in the cash market, through loans and securities. But foreign exchange (FX) derivatives, mainly FX swaps, currency swaps and the closely related forwards, also create debt-like obligations. For the US dollar alone, contracts worth tens of trillions of dollars stand open and trillions change hands daily. A currency swap agreement helps manage foreign exchange risk by exchanging interest payments in different currencies according to interest rate parity.

Is an FX swap a financial derivative?

Even so, rolling short-term hedges of long-term assets can generate or amplify funding and liquidity problems during times of stress. Focusing on the dominant dollar segment, we estimate that non-bank borrowers outside the United States have very large off-balance sheet dollar obligations in FX forwards and currency swaps. They are of a size similar to, and probably exceeding, the $10.7 trillion of on-balance sheet debt. On the other meme stocks side of the ledger, as much as two thirds of the dollar-denominated bonds issued by non-US residents could be hedged through similar off-balance sheet instruments. That fraction seems to have fallen as emerging market borrowers have gained prominence since the GFC. In a currency swap, the parties agree in advance whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction.

This matched global GDP in 2021 ($96 trillion) and was three times global trade ($29 trillion). And it exceeded both global external portfolio investment ($81 trillion) and international bank claims ($40 trillion) at end-2021. They offer a company access to a loan in a foreign currency that can be less expensive than when obtained through a local bank. They also provide a way for a company to hedge (or protect against) risks it may face due to fluctuations in foreign exchange.

Nor are we saying that the treatment needs to be identical, at least if the uses of the instruments and broader implications for financial stability are considered. Out of sight may not quite be out of mind, but a lack of transparency does complicate things. When the Great Financial Crisis (GFC) broke out, the FX swap market came under substantial strain (Baba et al. 2009, McGuire and von Peter 2009), as funding in the wholesale unsecured segment froze.

Together, they lend and borrow an equal quantity of money in two different currencies over a specified time period. A swap contract, unlike a standardised futures or options contract traded through a public exchange, is a customised agreement via the over-the-counter market (OTC), used to exchange future cash flows. Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. Swaps are mainly used by institutional investors such as banks and other financial institutions, governments, and some corporations. They are intended to be used to manage a variety of risks, such as interest rate risk, currency risk, and price risk.

Both parties have interest rate risk because interest rates do not always move as expected. The holder of the fixed-rate risks the floating interest rate going higher, thereby losing interest that it otherwise would have received. The holder of the floating rate risks interest rates going lower, which results in a loss of cash flow since the fixed-rate holder still has to make streams of payments to the counterparty. The outstanding amounts of FX swaps/forwards and currency swaps stood at $58 trillion at end-December 2016 (Graph 1, left-hand panel). For perspective, this figure approaches that of world GDP ($75 trillion), exceeds that of global portfolio stocks ($44 trillion) or international bank claims ($32 trillion), and is almost triple the value of global trade ($21 trillion).

The extent of the strains took many by surprise, as did the underlying demand for US dollars, especially as this came from European banks. Had the amount of FX swaps and the banks in need been more broadly known, the surge would have been less unpredictable or at least more easily understood. The funding disruptions were so serious that they prompted major central banks to put in place FX swap arrangements to channel the necessary US dollar funding to those that needed it most. A foreign exchange swap (also known as an FX swap) is an agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity. It is useful for risk-free lending, as the swapped amounts are used as collateral for repayment.