Currency Markets 101: FX Swaps and Cross-currency basis swap

One of the objectives of this blog is to spread financial literacy.

And considering the growing sophistication of financial markets, market participants may have learn, understand and perhaps consider using some of the available diverse tools to hedge on risks aimed at enhancing corporate returns or at financing investments.

This week we feature basics of FX Swaps and Cross-currency basis swaps which we will excerpt from a working paper by the Bank of International Settlements entitled “Price discovery from cross-currency and FX swaps: a structural analysis”

Note this is different from the US Federal Reserve instituted Swap lines as we discussed in How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets.

All highlights mine…

1. Cross-currency basis swap

There are numerous types of cross-currency swap contracts, among which the most widely used in recent years is a type of contract named the cross-currency basis swap. A typical cross-currency basis swap (hereafter “currency swap”) agreement is a contract in which Japanese banks borrow U.S. dollars (USD) from, and lend yen (JPY) to, non-Japanese banks simultaneously. Figure 1(i) illustrates the flow of funds associated with this currency swap. At the start of the contract, bank A (a Japanese bank) borrows X USD from, and lends X× S JPY to, bank B (a non-Japanese bank), where S is the FX spot rate at the time of contract. During the contract term, bank A receives JPY 3M LIBOR+α from, and pays USD 3M LIBOR to, bank B every three months. When the contract expires, bank A returns X USD to bank B, and bank B returns X× S JPY to bank A. At the start of the contract, both banks decide α, which is the price of the basis swap. In other words, bank A (B) borrows foreign currency by putting up its home currency as collateral, and hence this swap is effectively a collateralised contract.

These currency swaps have been employed by both Japanese and non-Japanese banks to fund foreign currencies, for both their own and their customers’ account, including multinational corporations engaged in foreign direct investment. Currency swaps have been also used as a hedging tool, particularly for issuers of so-called Samurai bonds, which are JPY-denominated bonds issued in Japan by non-Japanese companies. By nature, most of these transactions are long-term, ranging from one year to 30 years.

Illustration by BIS

2. FX swap

A typical FX swap agreement is also a contract in which Japanese banks borrow USD from, and lend JPY to, non-Japanese banks simultaneously. The main differences from the currency swap are that: (i) during the contract term, there are no exchanges of floating interest between JPY and USD rates; and (ii) at the end of the contract, the different amount of funds is returned compared with the amount exchanged at the start.

Figure 1(ii) illustrates the flow of funds associated with the FX swap. At the start of the contract, bank A (Japanese bank) borrows X USD from, and lends X × S JPY, to bank B (non-Japanese bank), where S is the FX spot rate at the time of contract. When the contract expires, bank A returns X USD to bank B, and bank B returns X × F JPY to bank A, where F Is the FX forward rate as of the start of contract. As is the case with currency swaps, FX swaps are effectively collateralised contracts.

FX swaps have been employed by both Japanese and non-Japanese banks for funding foreign currencies, for both their own and their customers’ account, including exporters, importers, and Japanese institutional investors in hedged foreign bonds. FX swaps have also been used for speculative trading. The most liquid term is shorter than one year, but in recent years, transactions with longer maturities have been actively conducted for purposes such as foreign currency funding for corporate direct investments and arbitrage activities with crosscurrency swaps. In fact, many market participants point out that the liquidity of FX swaps with maturities longer than one year has improved during the past several years.