Let's now look at cross currency swaps. A cross currency swap is an agreement between two parties to exchange interest rate payments in one currency, for interest rate payments in another currency. Unlike the standard interest rate swap where both payments are in the same currency, a cross currency swap involves two different currencies and includes an exchange of principal amounts.
To understand how they work think of them as a combination of an interest rate swap and an FX swap. Like an interest rate swap, the two parties exchange interest rate payments based on a notional amount. The difference is that in a cross currency swap, these payments occur in different currencies.
Like an FX swap, the two parties exchange principle amounts at the start of the contract and reverse the exchange at the end. However, unlike FX swaps, which use the spot rate for the initial exchange and the forward rate for the final exchange, cross currency swaps typically fix the FX rate at inception for both transactions. These mechanics make cross currency swaps particularly useful when an entity needs to convert both the principle and interest rate payments of a loan or investment into another currency.
For example, a company issuing debt in one currency but needing funds in another can use a cross currency swap to transform its liability into the preferred currency, effectively converting both the notional and interest payments into a more favorable structure.
Or an investor holding foreign currency denominated bonds can use a cross currency swap to hedge both exchange rate fluctuations and interest rate differentials, ensuring that returns remain stable in their home currency.
While both FX swaps and cross currency swaps facilitate currency conversion. They serve different purposes due to their distinct time horizons.
FX swaps are primarily used for short term funding needs often one to 12 months, and typically up to two years in the most liquid markets. While cross currency swaps are more commonly used for longer term financing, often ranging from three to 30 years.
