In a cross-currency swap, a loan in one currency is exchanged for one of equal value in another currency. Businesses use such swaps to gain a comparative advantage from one currency to another. This tends to mean moving the loan from one country to another.
Loans are an intrinsic part of global business. Multinational corporations take out loans in order to complete projects in other countries. The loan is divided into the amount borrowed, called the principle, and the interest payments paid on the loan. One of the other can be exchanged in a currency swap; however, the rate of interest remains the same.
By making a cross-currency swap, a company is able to acquire access to a foreign currency market. Native businesses naturally have greater access to loans and are more likely to get good terms. Companies therefore find foreign companies with mutual interests. The cross-currency swap gives a business the opportunity to save money when also obtaining money in a foreign currency.
For example, an American company may wish to acquire Russian rubles, while a Russian company is in need of U.S. dollars. The companies make an agreement to take out domestic loans of an equal value and with equal interest rate. The companies then make a formal agreement to exchange these loans and their interest payments.
A cross-currency swap is useful for reducing debt expenditure. Interest rates are not always fixed values. Swapping from one currency to another can reduce the rate, but it is also used to avoid likely rate changes. In this sense, it is a form of hedging. Hedging seeks to find a balance between currencies to protect businesses from sudden changes.
The cross-currency swap is different to the central bank liquidity swap. This kind of swap is a specially authorized exchange of currencies between central banks. These banks are the most important banks in any one nation and include the Federal Reserve in America and the Bank of England in the United Kingdom. Cross-currency swaps are just between businesses and do not involve central banks.
Loan exchanges are considered to be over-the-counter (OTC) derivatives. These derivatives are the term for traded contracts that do not pass through an exchange or some other form of intermediary. Interest rate swaps are similar in nature. An interest rate swap, however, does not include the principle of the loan.