Cross Currency Swaps

Back in the 1970s, currency swaps were first created as a means of eluding controls of foreign exchange within the UK.  During this period, companies in the United Kingdom were required to pay a high rate when borrowing using US dollars.  As a way of getting around this, companies began to establish back-to-back loan agreements with companies in the United States that were interested in borrowing Sterling.  Today, restrictions experienced during the 1970s on currency exchange are seldom seen although using back-to-back loans as a way of saving are used because of comparative advantage.

Then in 1981, cross currency swaps were developed and introduced by the World Bank.  With this, German marks and Swiss francs could be obtained by making an exchange of cash flow with IBM.  To see this deal through, it had backing by Salomon Brothers to a tune of $210 million US dollars that would be spread out over a 10-year period.  However, when the world financial crisis hit in 2008, the transaction structure for cross currency swaps was used by the Federal Reserve System in the United States.

In this case, the deal was made to set up central bank liquidity swaps, which meant an agreement to exchange domestic currencies at the current and prevailing exchange rate was made.  This involved the central bank of a stable and emerging or developed economy and the Federal Reserve Bank to work closely together.  The agreement also meant that the swap would be reversed at the same exchange rate but at a fixed, future date.  The purpose of this liquidity swap agreement was to provide liquidity in United States dollars to markets overseas.

The liquidity swaps made by the central bank and currency swaps are structured in much the same way, the one difference is that cross currency swaps are commercial transactions pushed by comparative advantage.  On the other hand, liquidity swaps with the central bank are designed as emergency loans of United States dollars, again to markets overseas.  Today, no one knows if in the long-term, these cross currency swaps would prove beneficial to the United States or to the United States dollar.

In summary, a cross currency swap is an agreement for foreign exchange between two parties so aspects can be exchanged, being the principal and/or interest payments of a loan made in one country’s currency that would be for equivalent aspects of an equal using the net and present value of the loan in another country’s currency.  While these swaps are similar to interest rate swaps, the one difference is that with cross currency swaps, exchange of the principal is involved.

When it comes to cross currency swaps being used to exchange loans, three ways are used to include the following:

1.    Principal Only – Of all cross currency swaps, exchanging just the principal with the counterparty is the easiest.  In this case, the agreement involves a function that would be equal to futures or a forward contract.

2.    Loan Principal with Interest Rate Swap – The second way in which cross currency swaps are handled is by combining the loan principal and an interest rate swap.  In this case, as the parties borrow on behalf of the other, the swap becomes the “back-to-back loan.”

3.    Interest Payment Cash Flows – The last way of using cross currency swaps is by using only the interest payment cash flow on loans that would be the same size and term but exchanged cash flows are in different denominations.  Because of this, the cash flows are not netted.