Cross-Currency Swaps
One company has dollars and needs euros; another is the opposite. A cross-currency swap lets them exchange principal and interest, then swap back at maturity.
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Text version · Interest Rates & Swaps, lesson 6: “Cross-Currency Swaps”
One company has dollars and needs euros; another is the opposite. A cross-currency swap lets them exchange principal and interest, then swap back at maturity.
Swap principal at the start, swap it back at the end
cross-currency swap: both sides first swap principal in two currencies at the day's exchange rate, pay each other interest in the other currency along the way, and swap the principal back at maturity.
Whatever the exchange rate does, the principal is swapped back at the original price
At maturity the principal is swapped back at the rate agreed at the start, regardless of the market rate then: both sides got the foreign currency they needed and hedged the exchange-rate risk.
Borrow whose money, pay whose interest
The US company got euros, so it pays €300,000 a year at the 3% euro rate; the European company got dollars, so it pays $543,500 a year at the 5% dollar rate. Each pays interest in the currency it borrowed.
Key takeaways
- A cross-currency swap exchanges principal in two currencies at the start; during the swap each side pays interest in the currency it received; at the end the principal is swapped back at the starting exchange rate.
- It helps companies raise foreign-currency funding more cheaply and hedge the exchange rate risk on the principal.
- Unlike an interest rate swap, a cross-currency swap usually exchanges principal.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Press ▶ to play to step 1: what did each side hand over at the start? What exchange rate was used?
- Look at steps 2–4: which currency does the US company pay interest in each year? Why?
- Jump to step 5: at maturity, which exchange rate is the principal swapped back at? How is this different from an interest rate swap?
- Drag “Exchange rate at maturity” to 1.00 (the euro weakens): how many fewer dollars would you get back without a hedge? Then try 1.20.
Quiz and explanations
- 1. At the maturity of a cross-currency swap…
- Answer: The principal is swapped back at the agreed exchange rate.At the end, the principal is swapped back at the exchange rate agreed at the start.
- 2. One of the main differences between a cross-currency swap and an interest rate swap is…
- Answer: A cross-currency swap usually exchanges principal.The principal in the two currencies really does change hands.
- 3. Through a cross-currency swap, a European company receives $10.87 million and pays interest at the 5% dollar rate. How much does it pay each year?
- Answer: $543,500.$10.87 million × 5% = $543,500. Whichever currency you receive, you pay interest in that currency.
Terms in this lesson
- cross-currency swap (Cross-Currency Swap): An agreement to swap principal and interest in two currencies, exchanging the principal back at a set rate at the end.
- exchange rate (Exchange Rate): How much of one currency you get for one unit of another.
- hedge (Hedge): An opposite trade that offsets the risk of an existing exposure.