Hedging Long-Tenor FX risk | Cross Currency Interest Rate Swaps
Updated: Nov 30, 2020
Most CFOs and Financial managers are familiar with the use of FX forward contracts to manage risk. They are easy to understand, customizable as to tenor and notional, and available at almost any bank or broker. To review, they are an agreement to exchange two currencies on a future date, at an exchange rate that is equal to the spot rate on the trade date plus forward "points" (which can be positive or negative.)
Forward points are calculated so as to preclude arbitrage. Without forward points, a trader could borrow funds in the low rate country and invest them in the high rate country without risk. Alas, that's not allowed. Calculating forward points is simple - see fig 1:
For hedging between the major currencies, forward points are small, amounting to less than 1%. When EM currencies are involved, forward points can become a major cost (depending on the direction of trade.) While EM forward points have come down in recent months due to central bank responses to Covid-19, they may be large enough to impact returns. For example, USDMXN hedge costs (as of May 11, 2020) are 4.6%/annum, USDINR are 4.9%. When longer tenors are involved costs can be extremely high. A three-year USDMXN contract is 12.4% (sell MXN/buy USD).
In addition, counterparties offering long-tenor forward contracts often require an initial margin deposit as a buffer against future negative mark-to-market valuations. Additionally, variation margin may be required if offside movements exceed a certain threshold. This can additionally impair returns and tie up capital in non-performing accounts.
It's clear that forward contracts are excellent vehicles for managing shorter tenors (< 12 months); if longer tenors are required (e.g. to hedge a multi-year foreign investment) they can be problematic. Fortunately, there is an alternative - cross-currency interest rate swaps.
Most financial managers are familiar with interest rate swaps. They are commonly used to convert a fixed interest rate flow into a floating rate flow, or the reverse. In addition to regularly (monthly, quarterly, etc) exchanged interest payments, they can have an exchange of notionals at either the beginning of the term, the end of the term, or both - whatever matches the obligation or asset. They're a popular product - $70Tr in USD swaps and another €25Tr in EUR IR swaps in Q2 2019.
In these vanilla IR swaps, both the pay and receiver leg are denominated in the same currency. When one leg is denominated in one currency and the other is denominated in a second currency, it is known as a cross-currency interest rate swap, aka XCCY.
The basic structure is shown in fig 2. This illustrates the hedging of an obligation, but it could as easily be a receivable. During the tenor (which can be multiple years), regular exchanges of interest payments are made. At the maturity date, the exchange of principle is made. Crucially, the exchange rate is the same rate as the inception spot (unlike the forward contract). The interim exchanges of differential interest payments are what enable this identical exchange rate.
The interest rate of the LC leg is determined by either the obligation (e.g. bond interest payments) or regular LC income from investments. The rate for the other leg is calculated from the two forward interest curves so as to achieve a zero NPV at inception, plus a spread for the swaps bank.
The main advantage of the XCCY are that the notional exchange at maturity is at the original spot rate. Additionally, because regular interest payments are exchanged, the credit risk is lower (but not non-zero), so often margin requirements are lower than for a forward contract, reducing non-performing equity tied up in margin accounts.
Underwriting the credit can be complex, and in some cases may require an ISDA/CSA agreement.
Cross currency IR swaps should be considered when these conditions are present:
Long tenors (> 12-18 months)
High and disadvantageous forward points
Cash flows are regular and predictable
Deaglo can help you decide whether XCCY or another hedge strategy is best for your specific situation.