Cross currency swap

A portfolio manager investing in a foreign market receives cash flows in a foreign currency. If the rupee moves against that currency before the money comes home, gains made abroad can shrink — or turn into losses — once converted back.

A cross currency swap is one of the tools used to manage that risk. Two parties agree, over the counter, to exchange a stream of interest payments in one currency for a stream of interest payments in another currency, and — unlike a plain interest rate swap — they typically exchange the underlying principal amounts too, both when the swap starts and when it ends.

Section 19.4 places the cross currency swap among the tools for managing asset and liability currency risk, right after credit default swaps. The workbook's definition: it is an over-the-counter (OTC) agreement to exchange a series of floating rate payments in one currency against a series of floating rate payments in another currency, and such a transaction generally has both an initial and a final exchange of notional principal too.

Because it is OTC, the swap's exact terms — notional amounts in each currency, the floating rate benchmarks used, the tenor, and the exchange rate applied to the principal legs — are negotiated bilaterally rather than standardised on an exchange, unlike an exchange-traded futures contract.

Illustrative figures. An Indian portfolio manager has committed US$2,000,000 to a US fixed-income mandate on behalf of an Indian client, funded by converting Rs 16,60,00,000 at Rs 83/US$.

To hedge the currency risk on both the running interest income and the eventual return of principal, the manager enters a cross currency swap: at inception, the manager exchanges Rs 16,60,00,000 for US$2,000,000 with the swap counterparty (the notional exchange), then receives floating rupee-linked interest and pays floating dollar-linked interest over the swap's life, and at maturity the principal legs are exchanged back — the manager delivers US$2,000,000 and receives Rs 16,60,00,000, regardless of where the actual USD/INR rate has moved to by then.

If the rupee has meanwhile weakened to Rs 90/US$, the un-hedged US$2,000,000 would now be worth Rs 18,00,00,000 — a currency gain the manager gives up by hedging — but if the rupee had instead strengthened to Rs 78/US$, the same US$2,000,000 would be worth only Rs 15,60,00,000, a loss of Rs 1,00,00,000 that the swap's fixed principal exchange protects the client from entirely.

Chapter 19, section 19.4 (Protecting Portfolios with Derivatives — Managing Currency Risk), defines the cross currency swap directly, grouped with forward contracts and credit default swaps as OTC hedging tools. Expect a question on what distinguishes a cross currency swap from a plain interest rate swap (the exchange of principal, in a different currency on each leg).

• A cross currency swap exchanges principal as well as interest — a plain interest rate swap in a single currency typically exchanges only interest, with no need to exchange principal since both legs are in the same currency.
• It is OTC, not exchange-traded — terms are negotiated bilaterally, unlike a currency futures contract.
• The swap protects the currency conversion, not the underlying investment's market performance — the US fixed-income mandate can still lose money on its own merits even with the currency risk fully hedged.
• Both legs of a cross currency swap described here are floating-rate — do not assume one leg is automatically fixed; the workbook's definition specifies floating payments exchanged for floating payments, in different currencies.