Contrast how FX swaps and cross-currency swaps work.
The idea
An FX swap and a cross-currency swap both let a party borrow one currency against another, but they are built differently. In an FX swap the parties exchange two currencies at the spot rate and agree to reverse the exchange at a forward rate on a set date, usually within a year. No interest is paid in between. The interest rate differential is embedded in the forward points, so the forward rate differs from spot. A cross-currency swap runs for longer, often several years. Principal is exchanged at the start and re-exchanged at the end at the original spot rate. In between, each side pays floating interest in its own currency, with the basis spread added to the non-dollar leg. Both are economically collateralised borrowing and show up as off-balance-sheet derivatives. The exam point is that the FX swap carries the differential in the forward rate and the cross-currency swap carries it in periodic interest payments. Rolling short FX swaps leaves rollover risk that a long cross-currency swap avoids.
Formulas
Dollar rate implied by an FX swap
r(USD) = [F × (1 + r(EUR) × t) ÷ S − 1] ÷ t
- F
- the forward rate, in USD per EUR
- S
- the spot rate, in USD per EUR
- r(EUR)
- the euro interest rate, annualised simple
- t
- the period, in years
Holds when covered interest parity holds. Forgetting the euro interest, or leaving the result unannualised, are the usual slips.
A practice question
Which description of an FX swap is most accurate?
- Two currencies are exchanged at spot and re-exchanged at an agreed forward rate, with no periodic interest in between. - correct
- Two floating interest streams in different currencies are exchanged every quarter over several years, with principal exchanged only at maturity.Why not: Describes a cross-currency swap but drops the principal exchange at the start and adds periodic interest payments that an FX swap does not have.
- A single outright purchase of one currency for another at a future date, with no exchange of currencies at the spot date and no reversal.Why not: Describes an outright forward. An FX swap has two legs, a spot exchange and a reverse forward exchange.
- An exchange of fixed-rate interest in one currency for floating-rate interest in the same currency.Why not: Confuses an FX swap with an interest rate swap, which involves a single currency and no principal exchange.
An FX swap pairs a spot exchange with an opposite forward exchange fixed at the outset. The interest differential is embedded in the forward points, so no coupons are paid. It is a collateralised borrowing of one currency against another.
A harder one
A party enters a 5-year cross-currency swap and a 3-month FX swap, each exchanging euros for dollars at the start. Which statement about the final exchange of principal is correct?
- In both swaps the principal is re-exchanged at the spot rate prevailing on the maturity date.Why not: Ignores that both swaps fix the re-exchange rate at inception, so no future spot rate is used.
- In the cross-currency swap the principal is re-exchanged at the initial spot rate; in the FX swap, at the forward rate. - correct
- In the cross-currency swap it is re-exchanged at a forward rate, and in the FX swap at the initial spot rate.Why not: Swaps the two conventions. The FX swap uses the forward rate, and the cross-currency swap reverses at the initial spot rate.
- In both swaps the principal is re-exchanged at the forward rate, because the interest differential must be recovered at the end.Why not: Applies the FX swap convention to both. In a cross-currency swap the differential is paid through periodic interest, not the final rate.
A cross-currency swap uses the initial spot rate for the final exchange because the interest differential has already been settled through the periodic floating payments. The FX swap has no interest payments, so the differential sits in the forward rate.
The hardest tier
A bank that has issued a EUR bond swaps the funding into USD using a 5-year cross-currency swap. The bond pays EURIBOR + 40 bp. In the swap the bank receives EURIBOR - 35 bp and pays the USD floating reference rate flat. Which is the bank's all-in USD funding cost?
- USD floating rate + 75 bp - correct
- USD floating rate + 5 bpWhy not: Nets the bond spread against the basis (40 - 35), when the negative basis is an extra cost to the dollar borrower.
- USD floating rate + 40 bp flatWhy not: Ignores the basis entirely, as if the swap were priced exactly at covered interest parity.
- USD floating rate - 35 bpWhy not: Counts the negative basis as a saving and ignores the bond spread; it is a cost to the party receiving the lower euro rate.
The bank pays EURIBOR + 40 on the bond but receives only EURIBOR - 35 from the swap, leaving a shortfall of 75 bp that it must cover. Add that to the USD leg it pays: USD floating rate + 75 bp. The negative basis raises the cost of dollars obtained via the swap.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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