Cross-Currency Swaps and Basis Risk
Cross-Currency Swaps and Basis Risk
A cross-currency swap exchanges both principal and interest payments in one currency for principal and interest payments in another currency. Unlike single-currency swaps, cross-currency swaps involve exchange of notional amounts at inception and maturity, creating FX exposure throughout the life of the trade.
Definition and Key Concepts
Core Structure
A cross-currency swap has three key components:
- Initial exchange: Notional amounts exchanged at the spot rate at inception
- Periodic interest payments: Each party pays interest in the currency they received
- Final exchange: Notional amounts re-exchanged at the original spot rate at maturity
Types of cross-currency swaps:
| Type | Fixed Leg 1 | Floating Leg 2 | Common Use |
|---|---|---|---|
| Fixed-fixed | Fixed USD | Fixed EUR | Liability hedging |
| Fixed-floating | Fixed USD | Floating EUR | Asset swaps |
| Floating-floating (basis swap) | Floating USD | Floating EUR | Funding optimization |
Basis Spread
The cross-currency basis is the spread added to one floating leg to equate the present values:
Basis spread definition: USD floating leg + 0 bps ↔ EUR floating leg + X bps
A negative basis means EUR borrowers pay a premium to access USD funding.
Historical context: During the 2008 financial crisis, the USD/EUR basis widened to -100 bps as European banks scrambled for dollar funding.
Key Terms
| Term | Definition |
|---|---|
| Notional exchange | Physical exchange of principal at start and end |
| Mark-to-market | Re-exchanging notionals periodically to reduce credit exposure |
| Basis points | Spread added to floating leg (typically the non-USD leg) |
| FX rate lock | Original spot rate used for final exchange |
How It Works in Practice
Payment Structure
Initial exchange (T+2):
- Party A delivers USD notional to Party B
- Party B delivers EUR notional to Party A (at spot rate)
Periodic payments (quarterly/semi-annually):
- Party A pays EUR floating (e.g., €STR + basis spread)
- Party B pays USD floating (e.g., SOFR flat)
Final exchange (maturity):
- Party A returns EUR notional to Party B
- Party B returns USD notional to Party A (at original spot rate)
Basis Spread Dynamics
| Market Condition | USD/EUR Basis | Implication |
|---|---|---|
| Normal markets | -10 to -20 bps | Modest dollar premium |
| USD funding stress | -50 to -100 bps | High demand for dollars |
| EUR funding stress | +10 to +20 bps | Euro premium (rare) |
| Central bank intervention | Near 0 bps | Swap lines stabilize markets |
Factors affecting basis:
- Relative monetary policy divergence
- Dollar funding needs of non-US banks
- Hedging demand from corporate treasurers
- Central bank swap line availability
Mark-to-Market Cross-Currency Swaps
To reduce counterparty credit exposure, some swaps include periodic notional resets:
| Feature | Traditional XCCY | MTM XCCY |
|---|---|---|
| Notional exchange | Start and end only | Quarterly resets |
| FX exposure | Accumulates over time | Limited to one period |
| Credit exposure | Higher | Lower |
| Collateral needs | Higher margin | Lower margin |
Worked Example
Trade details:
- USD notional: $50 million
- EUR notional: €45.45 million (spot rate: 1.10 USD/EUR)
- Tenor: 3 years
- USD leg: SOFR flat (quarterly, Actual/360)
- EUR leg: €STR + 25 bps (quarterly, Actual/360)
- Basis spread: -25 bps on EUR leg
Initial exchange:
- Party A delivers $50,000,000 to Party B
- Party B delivers €45,450,000 to Party A
First quarter payments (91 days):
USD leg (SOFR = 4.50%): USD Payment = $50,000,000 × 4.50% × (91/360) USD Payment = $50,000,000 × 0.045 × 0.2528 USD Payment = $568,750
EUR leg (€STR = 3.75%, spread = -25 bps): Net EUR Rate = 3.75% - 0.25% = 3.50% EUR Payment = €45,450,000 × 3.50% × (91/360) EUR Payment = €45,450,000 × 0.035 × 0.2528 EUR Payment = €402,031
Payment flows:
- Party A pays €402,031 to Party B
- Party B pays $568,750 to Party A
These are gross payments in different currencies (no netting).
Final exchange (at maturity, regardless of current FX rate):
- Party A returns €45,450,000 to Party B
- Party B returns $50,000,000 to Party A
FX Exposure at Maturity
If the EUR/USD rate moves from 1.10 to 1.20 over the 3-year term:
| Party | Receives at Maturity | Market Value | Impact |
|---|---|---|---|
| Party A | $50,000,000 | $50,000,000 | Neutral |
| Party B | €45,450,000 | €45,450,000 × 1.20 = $54,540,000 | Gain $4,540,000 |
Party B benefits because they receive EUR at the original rate (1.10) when EUR has strengthened (1.20).
Risks, Limitations, and Tradeoffs
FX Risk
The final exchange at the original spot rate creates significant FX exposure:
| Scenario | Party Receiving USD | Party Receiving EUR |
|---|---|---|
| USD strengthens | Gains on final exchange | Loses on final exchange |
| EUR strengthens | Loses on final exchange | Gains on final exchange |
This exposure compounds over longer tenors.
Basis Risk
Even if hedging FX and interest rate risk, basis spread movements create P/L:
| Initial Basis | Maturity Basis | Impact on MTM |
|---|---|---|
| -25 bps | -40 bps | Loss for EUR payer |
| -25 bps | -10 bps | Gain for EUR payer |
Basis risk is difficult to hedge directly.
Counterparty Credit Risk
Cross-currency swaps have higher credit exposure than single-currency swaps:
- Interest rate component: Similar to IRS exposure
- FX component: Grows with exchange rate moves
- Principal exchange: Full notional at risk at maturity
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Basis spread mismatch | Quoted basis differs from executed | Confirm basis in bps before execution |
| Holiday calendar errors | Different payment dates in different currencies | Align calendars or specify payment rules |
| FX rate discrepancy | Different rate sources at inception | Agree on fixing source (Reuters, Bloomberg) |
| Collateral currency mismatch | Posting EUR collateral on USD exposure | Match collateral currency to exposure |
Checklist and Next Steps
Pre-trade checklist:
- Confirm USD and non-USD notional amounts
- Verify spot FX rate for notional exchange
- Check basis spread on non-USD leg
- Confirm floating rate indices for both legs
- Review day count conventions for both currencies
- Verify payment dates and holiday calendars
- Confirm whether MTM or traditional structure
- Review CSA collateral terms and eligible currencies
Risk monitoring checklist:
- Track FX rate moves daily
- Monitor basis spread changes
- Calculate counterparty exposure weekly
- Review collateral requirements
- Stress test for FX shocks
Related articles:
- For interest rate swap basics, see Plain-Vanilla Interest Rate Swaps Mechanics
- For equity exposure alternatives, see Total Return Swaps for Equity Exposure