A cross-rate forward swap is a type of swap agreement that involves exchanging cash flows or assets in different currencies at a fixed exchange rate on a future date. It is a combination of a spot foreign exchange transaction and a forward foreign exchange transaction.
A cross-rate forward swap can be used for various purposes, such as hedging foreign exchange risk, arbitraging interest rate differentials, or gaining exposure to a different currency. For example, suppose a US company wants to borrow euros at a lower interest rate than the prevailing US dollar rate, and a European company wants to borrow US dollars at a lower interest rate than the prevailing euro rate. They can enter into a cross-rate forward swap, where they exchange the principal amounts in their respective currencies at the current spot rate, and agree to pay each other interest payments in their own currencies at a fixed rate. At the end of the swap term, they exchange the principal amounts back at the same exchange rate as the initial swap.
A cross-rate forward swap can be seen as a series of forward contracts, where each contract specifies the amount and date of the cash flow exchange. The exchange rate for each contract is determined by the interest rate parity condition, which states that the difference between the interest rates of two currencies is equal to the difference between the forward rate and the spot rate of those currencies. Therefore, the exchange rate for each contract is locked in at the inception of the swap, eliminating the foreign exchange risk for both parties.
Basic Theory
A cross-rate forward swap involves the exchange of cash flows in two different currencies at predetermined future dates. This financial instrument helps market participants hedge or speculate on changes in exchange rates between two currencies. The cross-rate is the exchange rate between two currencies that do not involve the U.S. dollar.
Procedures
- Identify the currencies involved: Determine the two currencies for which you want to establish a cross-rate forward swap.
- Obtain spot rates: Gather the current exchange rates for both currencies. The spot rate represents the current market rate for immediate currency exchange.
- Determine the cross-rate: Calculate the cross-rate using the formula:
Cross-Rate = Exchange Rate of Currency A / Exchange Rate of Currency B - Specify the notional amount: Decide the amount of each currency to be exchanged in the forward contract.
- Choose the forward rate: Agree on the future exchange rate for the cross-rate forward swap. This rate is often determined through negotiation between the parties involved.
- Calculate the forward points: The forward points represent the difference between the agreed-upon forward rate and the spot rate. Use the formula:
Forward Points = Forward Rate - Spot Rate - Set up the cash flow schedule: Prepare a schedule outlining the cash flows for each party involved in the swap at various future dates.
- Perform the calculation in Excel: Utilize Excel formulas to compute the cash flows, taking into account the cross-rate, notional amounts, and forward points.
Comprehensive Example
Let’s consider a scenario involving a cross-rate forward swap between the Euro (EUR) and the British Pound (GBP). The spot rate for EUR/GBP is 0.8500, and the agreed-upon forward rate is 0.8600 for a notional amount of €1,000,000.
| Date | Spot Rate | Forward Rate | Forward Points | EUR Cash Flow | GBP Cash Flow |
|---|---|---|---|---|---|
| 01/01/2024 | 0.8500 | 0.8600 | 0.0100 | -€1,000,000 | +£860,000 |
| 01/07/2024 | 0.8500 | 0.8600 | 0.0100 | -€1,000,000 | +£860,000 |
In this example, on January 1, 2024, Party A pays €1,000,000 and receives £860,000 from Party B. The forward points of 0.0100 account for the difference between the spot rate and the agreed-upon forward rate.
Result
The result of the cross-rate forward swap is a predetermined exchange of currencies at a future date, allowing both parties to hedge against currency risk.
Other Approaches
- Sensitivity analysis: Assess the impact of changes in exchange rates on the cash flows by adjusting the spot rate or forward rate in the Excel model.
- Scenario analysis: Consider different scenarios with varying spot rates and forward rates to analyze the potential outcomes under different market conditions.
- Monte Carlo simulation: Use Excel’s random number generation and simulation capabilities to model the uncertainty associated with exchange rate movements.
