A cross-currency swap is an agreement between two parties to exchange currencies at the spot rate. Cross-currency swaps are often made by financial institutions or large multinational corporations to access funds in foreign currencies at favorable rates.
Cross-currency basis swaps are often used by financial institutions and corporations to:
- Obtain foreign currency to pay for overseas assets.
- Hedge against currency fluctuations.
- Acquire foreign currency bonds as investments.
- Raise foreign money through bonds.
Cross-currency basis swaps: An example
Suppose Company A is a US company that wants to build a factory in Europe and needs 10 million euros. To get a loan in euros from a European bank would come with high interest rates.
Company B is a German company that needs US dollars to acquire high-tech equipment from a US company. Similar to Company A, Company B will pay a high premium to borrow US dollars from a US financial institution to pay for the equipment.
The solution is simple — Company A and Company B agree to get loans with lower interest rates in their own countries and their home currencies and then swap them between each other at spot rates. When the time comes to pay off the loan, these two companies swap currencies once again at the same exchange rate as when the first swap was made.
Cross-currency swaps are typically reserved for large companies. But that doesn’t mean you can’t speculate on currency exchanges or hedge against a potential US dollar decline. Forex brokers let you open an account, exchange currencies and make a profit whenever your currency appreciates against the one you sold.
In a cross-currency basis swap, you’re exposed to credit risk, because the other party could default, and interest rate risk, given that interest rates fluctuate.
Cross-currency swaps are designed to help companies access foreign currency at better terms and interest rates. Individuals can speculate or profit from currency exchanges with Forex trading.