A cross currency swap or CCS involves an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporation has a comparative advantage and to achieve a portfolio in a different currency of its choice, at a cost lower than if they accessed the market of the second currency directly. These types of swaps involve an exchange of two currencies and interest rates relevant to these two currencies. By its special nature, these instruments are used for hedging risk arising out of interest rates and exchange rates.
A swap is a form of a barter trade. Barter trade is the earliest form of swap transactions. Let’s take an example of a baker and a farmer. The farmer produces wheat, which is ground into flour and used by the baker to produce or bake bread. The farmer needs bread to eat and the baker needs wheat flour to bake bread. The farmer agrees to supply 10 kgs of grains to the baker but instead of charging the price for flour, he agrees to receive bread as payment. The baker can produce 50 loaves of bread in 10 kgs of wheat flour and agree to compensate the farmer with 20 loaves of bread. The baker would sell the remaining 30 loaves in the market to fund his bakery. So, if the price of wheat goes up or down, the baker is ensured of flour supply. And irrespective of the change in price of bread, the farmer is assured his supply of bread.
Swaps are usually traded in Over-the-Counter (OTC) markets. But the very wide and liquid nature of instruments has led to evolution of concept and now swaps are available on almost all asset classes. Even exchange traded swaps like Commodity swaps (Crude oil – Gasoline) and interest rate swaps (US Fed rate – Euribor) are available for electronic trading.
Cross currency swaps example
Reliance Industries Ltd., operate oil refineries, thus, crude oil is an input cost for them. Since, most of the crude oil is traded in US Dollars (USD), Reliance needs USD to buy crude oil. Whereas Costco, which owns petrol pumps across the US, needs to buy refined crude oil or gasoline from RIL against India Rupee (INR).
Suppose USD is currently at ₹ 80. RIL needs to import 100 barrels of crude oil at $100/barrel, it would need $10,000. Instead of borrowing the amount from a bank, RIL would swap $10,000 by exchanging ₹8,00,000 (80 * 10,000) with Costco, which Costco would agree to as it needs INR to fund purchase of gasoline from RIL.
RIL will pay a prevailing interest rate of 3.5% p.a. on $10,000 and Costco would agree to pay 7% p.a. on ₹8,00,000.
After RIL has received 100 barrels, it will process them and export gasoline to Costco. RIL would pay $10,000 upfront for the import of crude oil, the interest rate obligation would be calculated and settled at the end of the entire transaction. Similarly, Costco would pay RIL in INR to import ₹8,00,000 worth of gasoline.
Here, Reliance is able to raise funds at a cheaper rate and also at a fixed rate of USD to INR at ₹80, which means that even if the INR depreciated to 85 or 90 against USD, RIL would be comfortable returning its USD debt to Costco at pre-agreed rate, thus saving valuable funds. Cross currency swaps are frequently used by banks, corporates and Importers and exporters to hedge their currency exposure and secure physical trades as well.
Cross Currency Swap vs. Foreign Exchange Swap
Cross currency swaps and foreign exchange swaps are very similar and are often mistakenly used interchangeably. However, the major point of difference between these two is interest rate settlement. In cross currency swap, both counterparties make periodic interest payments in the currency they are borrowing. Unlike foreign exchange swap where the counterparties own the amount they are swapping, cross currency swap counterparties are lending the amount from their domestic bank and then swapping the loans.
Therefore, foreign exchange swaps are less risky because the swapped amount acts as collateral for repayment, while cross currency swaps are slightly riskier. They involve an element of default risk in the event the counterparty fails to pay interest payment obligation at maturity or pre-decided interval, leading to default on the loan.