What it means
A cross-currency swap starts with a simple mismatch. A business earns in one currency but has borrowed in another, so every movement in the exchange rate changes the real cost of its debt even though nothing about the business has changed.
The swap fixes that by exchanging both the interest payments and the principal with a counterparty, usually a bank. The company hands over the currency it borrowed in and receives the currency it needs, pays interest in its own revenue currency for the life of the deal, and reverses the principal exchange at maturity at the rate agreed at the start.
Why borrow in the wrong currency at all? Because debt markets are not equally deep or equally priced; a bond sold to investors in one market can be materially cheaper than the same bond sold at home, and the swap lets the borrower keep that saving without keeping the currency risk.
Two features cause most of the arguments. The exchange of principal makes a cross-currency swap much larger in credit terms than a plain interest rate swap, which is why banks demand collateral, and the pricing includes a cross-currency basis that moves with how badly the market wants one currency over another.
The accounting also needs planning. Treated properly as a hedge, the swap and the underlying borrowing move together in the accounts; treated carelessly, the swap is marked to market through profit while the loan sits at cost, which produces large swings in reported earnings that have nothing to do with trading.
In practice
Real-world examples.
Example
A European airline buys aircraft priced in dollars but sells tickets in euros. It funds the purchase with a dollar loan and swaps it into euros so that a stronger dollar cannot inflate its repayments while ticket revenue stays flat.
Example
A Canadian utility issues a long bond into a foreign market because domestic investors will not take 30-year paper in size. A cross-currency swap turns the foreign coupon and principal back into the currency its regulated tariffs are set in.
Example
A software group lends to its own overseas subsidiary and swaps the loan into the subsidiary's local currency. The group keeps a single internal rate for planning and the subsidiary's results stop swinging with the exchange rate.
Formula
Calculation
Effective cost in home currency = Interest paid on the swapped currency leg, with principal re-exchanged at the originally agreed rate
A manufacturer based in the United States earns most of its revenue in euros but can issue a dollar bond cheaply. It raises $100,000,000 at 6% fixed and enters a cross-currency swap at an agreed rate of $1.25 per euro. At the start it pays the bank $100,000,000 and receives EUR 80,000,000, because $100,000,000 / 1.25 = EUR 80,000,000. Each year it receives $6,000,000 from the bank, which exactly covers the bond coupon of 6% on $100,000,000, and pays the bank 4% on EUR 80,000,000, which is EUR 3,200,000. At the original rate that euro payment is worth EUR 3,200,000 x 1.25 = $4,000,000, so the company has converted a $6,000,000 dollar obligation into a euro obligation costing the equivalent of $4,000,000, matched to the currency it actually earns. At maturity it returns EUR 80,000,000 and receives $100,000,000 to repay the bondholders, whatever the spot rate has done in the meantime.Case study
Seen in the real world.
Halvorsen Instruments is an illustrative and entirely fictional scientific equipment maker whose sales are mostly in euros while its head office and its bank borrowings sit in dollars. For two years its reported profit moved more with the exchange rate than with order intake, and its lenders began asking awkward questions about covenant headroom.
The treasurer arranged a cross-currency swap over the full $100,000,000 of term debt, converting it into a euro obligation at a rate fixed on the day the swap was struck. The finance team also documented the arrangement as a hedge from day one, so that the swap's valuation changes and the loan's translation moved together in the accounts rather than fighting each other in the profit statement.
In the illustrative year that followed, the exchange rate moved sharply and the swap gained value while the dollar loan became more expensive in euro terms, the two effects cancelling as intended. The uncomfortable part of the story is the collateral: a large favourable move meant the bank demanded cash margin, and the treasurer had to keep a standby facility open purely to meet those calls.
Watch out
Common mistakes.
- Confusing a cross-currency swap with a plain interest rate swap, and so underestimating the credit exposure created by exchanging principal.
- Entering the swap and forgetting the hedge documentation, which turns a sensible hedge into a source of noisy mark-to-market gains and losses in the accounts.
- Ignoring the collateral consequences, since a swap that is working perfectly as a hedge can still demand cash margin at the worst possible moment.
Questions
People also ask.
Can CCS mean anything else?
Yes, outside finance it commonly refers to carbon capture and storage, and some organisations use it for customer care systems, so take the meaning from the document you are reading.
Does a cross-currency swap remove all foreign exchange risk?
It removes the risk on the hedged debt only; revenue, costs and any unhedged balances still move with the exchange rate.
Who are the usual counterparties?
Large banks, which quote the deal and then manage the resulting position, which is why creditworthiness and collateral terms matter as much as the headline rate.
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