Cross-currency swaps overview for corporates

Cross-currency swaps defined

A cross-currency swap is simply an agreement to exchange cash flows in one currency for cash flows in another currency at defined rates. For example, a company might enter an agreement with a hedge bank to receive a certain notional of USD at a fixed interest rate in exchange for paying a specified EUR notional at a different interest rate. Importantly, each leg of the transaction could be a fixed or floating rate.

Like any over-the-counter derivative, these trades are customizable. In some cases, there is an initial exchange of notional. In many cases, there is a final exchange of notional. In nearly all cases, there are interim interest payments, which may or may not include notional exchanges as well. The below graphic provides a common example.

Corporate use cases

A variety of use cases exist for cross-currency swaps in the corporate space. Among the most common for U.S.-based companies is the ability to create synthetic foreign currency debt.

1. Suppose a U.S. company has significant EUR-based revenue from its European subsidiary. To continue financing the EUR business and to match the revenue currency, the company would likely seek to issue EUR debt. However, in many cases issuing natural EUR debt is not feasible where the bulk of lender and capital relationships are U.S.-based. For those companies, issuing USD debt and entering into a cross-currency swap to create a synthetic stream of EUR interest payments can solve the goals of continuing to invest in the EUR business while also aligning the debt servicing currency with the revenue currency.
2. Similarly, if a company seeks to access less liquid debt markets, a cross-currency swap can be a faster and often cheaper way to achieve synthetic foreign financing. A common example is a U.S. company expanding in Brazil, where borrowing in reais may not be achievable, but the cross-currency market is quite liquid.
3. Another common use case falls within the context of cross-border M&A. A U.S. company seeking to acquire a foreign subsidiary may need foreign currency for the purchase price; moreover, similar to the reasons above it may want to align the debt interest payments with the currency of the expected EBIDTA from the acquired company.
4. A fourth example applies to hedging external and intercompany loans denominated in a foreign currency. If a company faces FX risk on a foreign-denominated loan, they could hedge each interest payment along with the principal remeasurement with an FX forward. An alternative approach would be to hedge the strip of interest payments and the principal remeasurement with a cross-currency swap. The main difference here is that the cross-currency swap would result in one fixed interest rate, rather than a series of rates that represent the FX forward curve. In either case, analysis can be performed to illuminate the pros and cons of each approach.

U.S. GAAP hedge accounting treatment

These over-the-counter products are highly customizable, and with varying structures come differing accounting designations. The table below illustrates various cross-currency swap structures, the risk being hedged, and the corresponding accounting designations available for those structures:

Companies execute cross-currency swaps to create synthetic foreign debt as a way of financing foreign operations. For companies looking to swap fixed functional currency debt to fixed foreign debt or floating functional currency debt to floating foreign debt, net investment hedge accounting may be available so long as the company has sufficient net equity in foreign operations to support the designation.

When designating a cross-currency swap as a net investment hedge, there are two strategies available to elect, the forward method and the spot method.

The forward method requires that all changes in value on the cross-currency swap be deferred into Other Comprehensive Income (OCI), a component of equity, and those gains and losses remain there until a complete or substantial liquidation of the foreign operations occurs. This allows companies to limit unwanted P&L volatility; however, the P&L does not reflect the foreign interest rate which is a part of the overall economic objective.

Under ASU 2017-12: Targeted Improvements to Accounting for Hedging Activities, many companies utilize the spot method where they are not only able to limit unwanted P&L volatility, but the interest accruals and settlements are recorded to the income statement as they occur, allowing companies to align the financial reporting with the economic objective of the strategy.

For companies looking to hedge external or intercompany foreign denominated loans by fixing foreign denominated cash flows into functional currency, a cash flow designation is commonly applied. From a financial reporting standpoint, the non-functional currency interest and principal repayment cash flows (as well as the related remeasurement) impact earnings on a consolidated basis. The benefits of a cash flow hedge accounting designation for this use case are two-fold:

1. Unwanted P&L volatility is removed from the income statement.
2. Gains and losses are reclassified to the P&L as the hedged transactions (i.e. interest accruals and coupons and principal remeasurement) occur and matching is achieved within the financial statement line item.

To qualify for cash flow hedge accounting, companies are required to assert that the hedged transactions are probable of occurring throughout the life of the hedging relationship, which in practice is an 80% or higher threshold. Repaying loans early impacts this assertion and therefore companies who have less certainty of short to medium term capital structure decisions may opt for a fair value hedge of FX risk as opposed to the cash flow designation which does not require the stringent probability assertion.

A fair value hedge designation of FX risk, though less common for Corporates, may be an alternative to applying cash flow hedge accounting for some companies. The financial reporting results appear almost identical though the designation comes with its own unique set of challenges.

Deconstructing cross-currency swaps

With the above details merely scratching the surface of cross-currency swaps, there are a host of other considerations to understand before implementing a cross-currency swap strategy. Among those considerations are the methodology behind mid-market pricing, how banks think about charges, bespoke structures, final exchange impacts, and accounting nuances of all of the above.