Cross Currency SWAP
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What is a Currency SWAP?
A Currency swap is a dual, simultaneous foreign exchange trade, one spot in one direction and the other forward in the other direction, with the same counterparty. The two counterparties exchange financial flows of the same nature, denominated in two different currencies.These two transactions are traded simultaneously with the same spot exchange rate used as a reference.In addition to its function as a foreign exchange instrument, it is also a dual treasury operation. For example, buying Dollars for cash in exchange for Euros (which you sell) and selling them in the long term for Euros which you buy back, is equivalent in terms of flows, to borrowing Dollars and lending Euros. This trade has a cost that will represent the interest rate differential between the 2 currencies.This difference is called either deferral or offset.
Concepts of offset and deferral
A deferral is a positive amount (which is added to the spot price).The future value is therefore greater than the present value. The party that buys currency 1 in cash will sell it at a higher price to compensate for the interest rate differential (fixed by the central banks) between the 2 currencies. Buying currency 1, when it is deferred in relation to currency 2, causes a buyer who is moving towards a lower interest rate, to lose money.
An offset is a negative amount (which is deducted from the spot rate).The future value is therefore lower than the present value. The party that buys currency 1 in cash will sell it for less in the long run to compensate for the interest rate differential between the 2 currencies. Buying currency 1, when it is offset in relation to currency 2, would effectively make money for the buyer who is moving towards a higher interest rate.
We can therefore conclude that if the interest rate on currency 1 is higher than the interest rate on currency 2, currency 1 is offset by currency 2. Otherwise 1 will be deferred relative to currency 2.
Calculating a currency Swap
The formula for a swap is as follows:
S=CC*n* (t2-t1)/ (1+t1)
S= Swap
N = Number of days
(t2-t1) = interest rate differential
The swap price can also be determined from the forward (CT) and spot (CC) rates by the following calculation:
S=CT-CC
You have to do this calculation twice to determine the bid/ask.Let’s look at an example:
The EUR/USD spot is at 1.2740 - 1.2743.The forward rate is quoted at 1.2710 - 1.2715.
The calculation is thus as follows
Left hand side:1.2740 - 1.2710 = 30
Right hand side:1.2743 - 1.2715 = 25
When the swap points are higher on the left than on the right, both are assigned a ‘-’ sign. Effectively, the € is offset in relation to the $ because the $ rate is lower than the € rate.
Swaps are always quoted in points (pips).
Advantages of Currency swaps
Currency swaps have several advantages. First of all, they don’t generate a balance sheet increase.This is a definite advantage over traditional loan operations for companies.Swaps are a commitment to redeem/resell foreign currency at a future date.This prevents companies from having certain ratios, such as the ratio of permanent capital to the balance sheet total, downgrade their ratings with rating agencies. Swaps also provide very high liquidity.
Finally, the two counterparties can set up a foreign exchange swap by deciding on all the characteristics such as maturity, amount and price.So it is a very flexible instrument.
Currency swaps in practice
A Currency swap is in fact an exchange of debt between two counterparties. The trade consists of 2 steps:
- Exchange of capital: the two counterparties exchange the nominal amount of their respective debts or deposits. The spot serves as the reference for the trade, which is a cash exchange transaction.
- Repayment of principal: at maturity, the two counterparties exchange the interest and value of a loan or deposit in one currency for its value in the other currency.
It is therefore, in fact, a cash flow transaction with payment of the capital on the spot date and repayment of the principal and interest at maturity.
There is also another type of swap that works in the same way, which is a cross-currency swap, which exchanges medium or long-term interest rates in two different currencies. For example, there might be a 3 month USD exchange for a 6 month EUR.
Application of currency swaps on the spot market
A customer wants to buy a 3 month Euro against a 3 month USD.
Trade date 11 February Spot value date 13 February Spot EUR/USD 1.0710/14 USD 3 Month interest rate 1.25 / 1.35 % EUR 3 Month interest rate 2.60 / 2.70 % interest rate 90-day deadline (13 May)
How to calculate the offered EUR/USD 3 Month futures price.
1st Method
Forward points = [ Spot* (1 + (SCI* n/360)) ] / [ (1 + (BCI* n/360)) ] - Spot
SCI = Second Currency Interest Rate
BCI = Base Currency Interest Rate
Forward points = [ 1.0714* (1+ (0.0135 * 90/360)) ] / [ (1 + (0.026 * 90/360)) ] - 1.0714
SWAP= - 0.0033
Forward rate = 1.0714 – 0.0033 = 1.0684
2nd method
The customer buys 3 Months Euro against USD at 1.0681 13 May value.
To calculate the swap that applies to you every night: you just have to take the last calculation and take "n=2".
This calculates whether you will gain or lose on the evening swap. Be aware that there is no point in cutting a position just before the swap and resuming it afterwards; you will pay back the Spread which is generally more expensive than the swap (especially if the swap was in your favour).
Another note: you can always ask your Broker for swap prices, if they are not already displayed on his website or on your platform.
Finally: be aware that brokers still take a small margin on the swap (or round off in their favour).
