Cross-Currency Basis Swaps
With an interest rate swap, you just swap the interest rates of the notional amount.
How much cash is usually exchanged with each settlement?
Of course.
Actually, no; it's just the difference in most cases.
If the counterparties faced 4.21% and 4.23% of USD 100 million notional, it would be silly to send over USD 4 million to each other. Just have one pay the other that two-basis-point difference, or USD 20,000.
Currency swaps can be similar. A floating interest rate on a notional EUR with a floating interest rate on a notional USD, perhaps. Maybe there's a German company that needs a USD loan for the start of a US operation. What would be easier for the German firm to borrow?
Sure. But the main issue is cost. The German firm would prefer to borrow EUR if there was a low local interest rate.
Probably not. It would be easier to just contact the local bank and get the local currency: EUR. But the main issue is cost. The German firm would prefer to borrow EUR if there was a low local interest rate.
So with this local EUR loan, it swaps the notional principal for an equivalent amount of USD. Now it's set up just as if the German firm had borrowed USD to begin with.
Then interest must be paid. What interest payment will the German firm make in the swap?
Then would the German firm prefer to just exchange net interest differences through time, or all of that notional principal in each currency?
That wouldn't be preferred. Recall the point of this loan in the first place.
Absolutely.
The whole point of this loan was that the German firm needed USD. So the notional principals will be exchanged at the start of the swap so that they can be exchanged back at the end. This is a **cross-currency basis swap**. What's really nice about it is that the German firm will essentially get the USD loan by borrowing in EUR first, without having to worry about currency risk.
Actually, one is clearly preferable. Recall the point of this loan in the first place.
Not quite. Consider that the swap has essentially created a USD loan.
Right. The German firm borrowed EUR locally and must make those local payments of EUR at the German interest rate. Those interest payments are *received* in the swap and passed along to the German bank. But the German firm used the swap to create a USD loan, so it will pay USD interest based on the US interest rate.
That's not it. The idea is essentially creating a USD loan for the years of this US project.
How would you expect the US firm to react if the EUR strengthened against the USD just before the end of this cross-currency basis swap?
Not really. There would be no reason to celebrate since the same notional amount of currencies are being returned at the end of the swap.
Not really. There would be no loss, since the same notional amount of currencies are being returned at the end of the swap.
Yes. The idea again is locking in a reasonable interest rate for this foreign loan, but without having any foreign exchange risk. The same notional amount is exchanged at the end as was in the beginning, so any exchange rate difference doesn't matter.
Now for the mechanics of how this works, exactly. Suppose that the German firm borrows EUR 20 million notional and the swap is for this and USD 22 million notional on the other side. The German firm borrows the EUR locally at a semiannual reference rate plus 50 basis points. Then the cross-currency basis swap is created with a swap dealer for the same reference rate with a basis, like -20 basis points.
What does this mean for the German firm's EUR loan?
Not quite. There's a +50 basis points on the local loan side and a basis of -20 basis points on the swap side, both coupled with the same reference rate.
Exactly.
Suppose the reference rate is 2% after six months. The German firm must pay interest to the local bank.
> $$ \text{ EUR } 20 \text{ million } \times ( 2 \% + 0.5 \% ) \times \frac{180}{360} = \text{ EUR } 250{,}000 $$
This is covered mostly from the swap payment to the German firm:
> $$ \text{ EUR } 20 \text{ million } \times ( 2 \% - 0.2 \% ) \times \frac{180}{360} = \text{ EUR } 180{,}000$$.
Whatever the reference rate, the difference then is a fixed EUR payment for the German firm beyond the swap:
> $$ \text{ EUR } 20 \text{ million } \times [( 0.5 \%) - (- 0.2 \% )] \times \frac{180}{360} = \text{ EUR } 70{,}000$$.
No, there's nothing extra for the German firm in EUR. The swap dealer won't be paying more than the full interest on the bank loan.
How would you expect this fixed cost of EUR 70,000 plus the USD side of the swap interest to compare to the interest on US loans available to the German firm at the beginning?
Probably not. Considering the choice made, a differential is much more likely.
Absolutely.
Keep in mind that this is the whole point of borrowing locally and then entering into a swap. There has to be a benefit over the simple USD loan.
Very unlikely. If that was the case, the German firm would have just taken a USD loan.
Suppose the loan would have been a US reference rate of 2.4% plus 90 basis points, but the swap payment is based just on this reference rate. What will the German firm pay into the swap for interest?
Perfect!
Not quite.
Very close; but remember that this is a semiannual payment setup, so you need to cut that in half.
Every six months, the semiannual USD interest payment is calculated based on the reference rate. This time, it's:
> $$ \text{ USD } 22 \text{ million } \times 2.4 \% \times \frac{180}{360} = \text{ USD } 264{,}000$$.
With the addition of EUR 70,000 payment, which is equal to USD 77,000 in this case, the total semiannual payment is USD 341,000, where it would have been USD 363,000 with the US loan.
What would you think would serve as the main determinant of the basis in a cross-currency basis swap?
Not really. The dealer can choose certain things, but these values are driven by something larger.
Sure.
There's a lot of demand for USD. So firms that want to borrow USD like this German firm did will have to accept lower payments in exchange, leading to the negative basis. In recent years, a basis from -10 to -50 basis points has been common for the EUR, CAD, and GBP, for example.
No, this is a free-market value.
To summarize:
[[summary]]
Just the differential
The full interest amounts of the notional
EUR
USD
The German interest rate on USD
The US interest rate on EUR
The US interest rate on USD
Net differences
Notional principals
No preference
It would be happy
It would be unhappy
It would be indifferent
Interest payments are exactly covered by the swap
Interest payments will leave the German firm with extra EUR every six months
Interest payments will be a fixed charge for the German firm every six months
It should be the same
It should be cheaper than the loan
It should be more expensive than the loan
Other responses
264000
528000
Relative demand for currencies in funding
The dealer's choice of spread quotes
Regulatory agencies that determine basis limits
Continue
