4: Cross Currency Swaps … How is it Different from an IRS

Mini Chapter Four

Cross Currency Swaps

• A variation of interest rate swaps, cross currency swap as the name suggests is a swap between two different currencies exchanged either in a fixed/fixed, fixed/float or float/float format. One can think of a CCS contract as a borrowing of one currency (paying interest rate on it) in exchange of lending the other (receiving interest rate on it). At the end of the contract the notional exchange is reversed i.e. the borrowed currency is returned (sold back) and the one lent comes back (bought back). This determines the direction of the FX swap trade. Market practice generally references the direction of the base currency at the far leg of the contract (USD, EUR, JPY et al.) to address the CCS direction. For instance, lending USD to borrow/generate KRW is equivalent to a sell/buy FX swap or a paying KRW rate/receiving USD rate i.e. buying USD in a USDKRW cross currency swap.

• FX risk in a cross currency swap – while a CCS is the exchange of interest rates on loans in two different currency notionals, the FX risk in the contract depends on the outstanding cash flows of the trade:
  • When both initial and final exchange are outstanding – magnitude of the FX risk is to the extent of the PV of the local currency leg, that’s much smaller compared to the notional.
  • When only the final exchange is outstanding – magnitude of the FX risk is to the extent of the full local currency notional or PV of the local currency leg of the swap.

Table 2 – Comparison between IRS (Single Currency Swap) and CCS

	IRS	CCS
Notional Exchange	No	Mostly yes, though coupon only swaps don't have any notional exchange
FX risk	No	Yes as stated above
Type of swap	Fixed/Float typically, float/float on 2 different indices of the same currency	Fixed/Float, Fixed/Fixed (typically used for corporate liability swaps), Float/Float
Discount Curve	Function of CSA	Function of CSA
Credit and Funding charges	CVA and FVA as discussed earlier	CVA and FVA charges are larger owing to FX vol risk on foreign currency notional in addition to rates vol
Duration/Rates risk	Same as the duration of the fixed rate leg	that of fixed rate leg in case of fixed/floating and could be on both legs in case of fixed/fixed
Unwind Value	Function of change in interest rates for onshore swaps. For USD based investors trading local currency swaps there is spot FX risk on unwind.	Function of change in interest rates and Spot FX rate.

Source: Pandemonium.

• Lastly – FX swap is a variation of a zero coupon fixed/fixed cross currency swap where the zero coupon IRR of the local currency leg is determined by the far leg FX rate or the FX outright (also called the FX implied as calculated in Table 3 below) of the contract.

Cross Currency Basis Swap

Cross Currency Basis Swap – is simply a float/float cross currency swap and primarily a financing instrument traded in the inter-bank market as a foreign currency floating rate against the hard/benchmark currency floating rate +/- spread. Basis swap levels therefore are an indicator of the magnitude of funding cost of the local currency in terms of the foreign currency.

In terms of cash flows they can be understood as a series of FX swaps, reset at prevailing market rates.

Indicative terms of a basis swap contract for client ABC: assuming client pays 5y USDJPY cross currency basis swap (JPY TONA/OIS vs USD SOFR)

Trade Date: Today
Swap Start Date: T+2/Spot Date/Forward Start IMM date
Maturity Date: end date as per the tenor of the basis swap (eg. 5y)
Notional Amount: Generally in base currency (eg. USD 100 mio)
Foreign Currency Notional: USD 100 mio x USDJPY FX rate effective on the start date
Notional Exchange: at start date and maturity
JPY Floating Rate: JPY TONA/OIS
USD Floating Rate: SOFR – xxx spread
JPY Floating Rate Payer: ABC i.e. borrows JPY and lend USD
USD Floating Rate Payer: Dealer i.e. lends JPY and borrows USD
JPY Floating Rate index Convention:
USD Floating Rate Convention: 3m USD SOFR compounded
Holiday Convention: Tokyo, New York

• Trivia

While basis swaps have been dealing for a long time in deliverable and developed market currencies – they have unfortunately not gained as much popularity with developing Asian markets. That’s primarily because the Asian local currency floating benchmarks were non-existent prior to the Asian Financial Crisis. There were literally no domestic interest rate policies or domestic swap (IRS) markets. Whereas there were vibrant long dated FX markets which facilitated the development of Fixed (local currency)/ Float (USD) longer dated cross currency swaps much earlier. To this day one doesn’t readily find liquidity in basis swaps in these Emerging market currencies and basis quotes are backed out of fixed float CCS and IRS / NDIRS separately.