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What is a cross-currency basis swap?
A cross-currency basis swap is a foreign exchange derivative that could let you acquire foreign currency at a better price.
How cross-currency basis swaps work
When you enter into a cross-currency basis swap, you:
- Borrow an amount of currency from another party, and
- Lend the equivalent amount in a second currency to that party at the same time.
While the swap is active, you exchange floating interest rate payments with the other party. At the end of of the swap, you and the other party return the money you’ve borrowed from each other at a prearranged exchange rate.
What is a floating interest rate?
A floating interest rate moves with a market or an index, as opposed to a fixed interest rate that stays the same throughout the duration of a loan.
The floating interest rate is also known as a variable rate or adjustable rate.
Why is a cross-currency basis swap useful?
Cross-currency basis swaps are often used by financial institutions and corporations to:
- Obtain foreign currency to pay for overseas assets.
- Acquire foreign currency bonds as investments.
- Raise foreign money through bonds.
Cross-currency basis swaps: An example
Let’s say you run a business in the United States but want to buy a warehouse in Italy.
You take out a mortgage on the warehouse that requires mortgage payments in euros. But because your company is in the US, you primarily receive dollars when conducting business.
This requires you to convert your dollars to euros to pay your mortgage in Italy.
Unfortunately for you, the dollar is weakening against the euro. That means your mortgage payments are getting more expensive.
A cross-currency basis swap may help. What it does is allow you to borrow dollars and convert them into euros at a fixed rate. It effectively lets you take out a loan and make interest payments in dollars — your home currency — rather than euros.
Compare providers that can help you set up cross-currency basis swaps
Are there any drawbacks?
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.
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