FX Swaps and Cross-Currency Basis Swaps
FX Swaps and Cross-Currency Basis Swaps are used to fund, manage or raise capital in foreign markets. Here’s how these instruments work (Ref: BIS Quarterly Review, Mar08):
📝 FX Swaps
📖 Definition: A contract in which one party borrows one currency from, and simultaneously lends another to, the second party. Each party uses the repayment obligation to its counterparty as collateral and the amount of repayment is fixed at the FX forward rate as of the start of the contract. Thus, FX swaps can be viewed as FX risk-free collateralised borrowing/lending.
⚙️ Mechanism: The chart below illustrates the fund flows involved in a euro/US dollar swap as an example. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B, where S is the FX spot rate. When the contract expires, A returns X·F USD to B, and B returns X EUR to A, where F is the FX forward rate as of the start.
🎯 Purpose: Used to raise foreign currencies, both for financial institutions and their customers, including exporters and importers, as well as institutional investors who wish to hedge their positions. They are also frequently used for speculative trading, typically by combining two offsetting positions with different original maturities.
⏰ Maturity: Generally are less than 1 year in maturity.
📝 Cross-Currency Basis Swaps
📖 Definition: This is a contract in which one party borrows one currency from another party and simultaneously lends the same value, at current spot rates, of a second currency to that party. The parties involved in basis swaps tend to be financial institutions, either acting on their own or as agents for non-financial corporations.
⚙️ Mechanism: The chart below illustrates the flow of funds involved in a euro/US dollar swap. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B. During the contract term, A receives EUR 3M Libor+ α from, and pays USD 3M Libor to, B every three months, where α is the price of the basis swap, agreed upon by the counterparties at the start of the contract. When the contract expires, A returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the start of the contract.
Though the structure of cross-currency basis swaps differs from FX swaps, both serve the same economic purpose, except for the exchange of floating rates during the contract term.
🎯 Purpose: Used to fund foreign currency investments, including multinational corporations engaged in foreign direct investment. They have also been used for converting currencies of liabilities, particularly by issuers of bonds denominated in foreign currencies.
⏰ Maturity: Generally range between 1–30 years in maturity.
In summary, FX swaps are primarily used for short-term currency exchange transactions, while cross-currency basis swaps are used for longer-term financing or investment purposes. FX swaps involve both spot and forward transactions, while cross-currency basis swaps involve exchanging cash flows denominated in different currencies. Both instruments play important roles in managing currency risk, funding needs, and investment opportunities in global financial markets.
