Traders new to the forex market might confuse the terms FX swap and cross-currency swap since both include a reference to currencies and a swap. These two over-the-counter products from the derivatives market are so dissimilar, however, that they are quoted by completely different trading desks.
This article will explain how these two types of currency-related swaps, which operate in the swap market, differ in practice and provide additional information about how FX and cross-currency swaps work and who might use each of these products.
What is an FX Swap?
A foreign exchange swap, FX swap or forex swap consists of a transaction with two legs that forex traders or hedgers can use to change or swap the value date of a forex position to another value date that usually lies further out in the future.
In addition, some forex traders might use the jargon term swap to refer to the swap points expressed in pips that forward traders quote to execute an FX swap transaction. In general, both legs of an FX swap transaction will involve the same notional amount of one currency in the pair, so the forex market risk involved in an FX swap transaction is minimal.
FX swaps are routinely performed by professional forex traders and by online forex brokers for their trading clients who run positions overnight to keep their positions’ value spot. This sort of FX swap is called a tom/next swap or a rollover, although FX swaps can be quoted for any set of two value dates.
- Flexible and efficient risk management for foreign exchange
- Minimization of transaction costs and reduced exposure to exchange rate volatility
- Opportunity for arbitrage and profit generation in the forex market
- Simplicity in shifting value date while maintaining currency amounts
- Counterparty risk potential in FX swaps from possible default
- Complexity and need for deep market understanding in FX swaps
- Liquidity constraints may pose challenges for executing large FX swap transactions
What is a Cross-Currency Swap?
A cross-currency swap is sometimes called a foreign currency swap or a currency swap, and it is also a two-legged transaction. This over-the-counter derivative product is typically transacted among interest rate dealers and their clients. In general, a cross-currency swap involves exchanging or swapping the cash flows on loans in different currencies.
A cross-currency swap involves exchanging or swapping the cash flows on loans in different currencies. A currency swap contract typically involves an initial exchange of currencies in a particular notional amount and contains specific terms regarding how that sum will be repaid during the swap’s lifetime.
A cross-currency swap includes swapping the stream of interest payments on a loan denominated in currency A for the stream of interest payments on a loan denominated in currency B.
Since a cross-currency swap involves exchanging one national currency for another, it involves significant forex market risk for both counterparties. This feature can be used by a speculator to take forex market risk or by a hedger to mitigate an existing forex market exposure.
- Can help companies access funding in foreign currencies at more favorable interest rates
- Allows companies to take advantage of interest rate differentials between countries
- Can help reduce borrowing costs by taking advantage of lower interest rates in another currency
- Not suitable for companies with limited resources or uncertain cash flow
- Requires high expertise in forex market and interest rate movements
- Exposes companies to counterparty risk if obligations are not met
Key Differences Between Cross-Currency Swaps and FX Swaps
Despite the confusing similarity in their names, cross-currency swaps and FX swaps are very different products. While both products are traded in the over-the-counter market, the cross-currency swap is a derivative that will be quoted by interest rate dealers, while the FX swap is not a derivative and will be quoted by dealers operating on forex forward desks.
Exchange of Interest Rate Payments
A key difference between the two products is that a cross-currency swap involves the exchange of interest rate payments on a series of dates among the counterparties. In contrast, an FX swap only involves doing two forex transactions in opposite directions for different value dates.
Complexity in Quoting
Another major difference between a cross-currency swap and an FX swap is the degree of complexity involved in quoting the two products. A cross-currency swap is a relatively complicated interest rate product that involves exchanging two streams of cash flows in loan interest payments in different currencies, which requires a fairly advanced calculation to quote.
In comparison, the FX swap is a much simpler forex product that involves shifting the value date on a forex position by buying a currency pair for one value date and selling the same pair for another, keeping the amount of one currency the same. The quote for an FX swap depends on the prevailing Interbank deposit rate differentials between the two dates that are used to generate the quoted swap points using a relatively easy calculation.
Forex Exposure and Market Risk
A final key difference is that a cross-currency swap creates or offsets a forex exposure, while an FX swap is almost entirely neutral with respect to forex market risk, although it does create an exposure to the interest rate differential between the two currencies involved. Cross-currency swaps involve taking on exposure to relevant market interest rates and changes in cross-currency swap valuations.
Example of a Cross-Currency Swap
As a fairly common real-world example of the application for a cross-currency swap, companies in different countries might agree to exchange loan amounts and interest rate payments to offset existing foreign currency exposures. They might do this to obtain better funding terms than they could otherwise achieve in a foreign market.
Consider the case of U.S.-based Company A, which needs to buy pounds sterling to finance its U.K. operations and U.K.-based Company B, which needs U.S. dollars to purchase fossil fuels.
In this situation, Company B has good access to U.K. debt markets and could get better terms on a pound sterling loan or bond issue than Company A, while Company A has preferential access to U.S. debt markets and can get more favorable terms on a U.S. dollar loan or bond issue than Company B.
If they need similar loan amounts given the current GBP/USD exchange rate or spot rate, they could decide to engage in a cross-currency swap whereby they each exchange domestic for foreign debt. This cross-currency swap would allow U.K.-based Company B to get a better loan and make interest payments in U.S. dollars while U.S.-based Company A gets a better loan and makes interest payments in pounds sterling.
In this case, each company agrees to exchange the notional amount of the loan expressed in their respective domestic currencies on the transaction date of the cross-currency swap, usually at the prevailing exchange rate.
Going forward, they agree to make the interest rate payments in the currency that is foreign to them until the loan matures. At maturity, they will again exchange the loan’s notional amount at a pre-determined exchange rate.
Considerations for Forex Traders
Understanding the differences between cross-currency swaps and FX swaps is important for traders and investors in the forex market. FX swaps offer flexibility and simplicity in managing foreign exchange risk, while cross-currency swaps provide opportunities for accessing funding and reducing borrowing costs. However, cross-currency swaps require expertise and involve counterparty risk. Market participants should consider these nuances to make informed decisions and optimize their forex strategies.
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Frequently Asked Questions
Is a cross currency swap an interest rate swap?
Yes. A cross-currency swap involves exchanging a series of loan interest rate payments or loan principal amounts that are denominated in two different currencies.
Do cross-currency swaps have FX risk?
Yes, cross-currency swaps entail exchanging loan-related cash flows in one currency for another, so a forex market exposure can indeed be created, although they can be used for hedging an existing forex exposure.
Is an FX swap a derivative?
An FX swap is not a derivative since it involves exchanging one value date for another on a forex position, although derivative contracts like options and futures can be swapped to another value date.
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