Cross-Currency Swap to Convert USD Debt to EUR
A US telecom company has just issued USD 250m of five-year fixed-rate notes at 5.25%. It wants EUR fixed-rate exposure because its largest division reports in EUR, and it enters a five-year cross-currency swap with a bank. Spot EUR/USD is 1.0850. Under the swap the company pays EUR fixed 3.05% and receives USD fixed 5.15% on USD 250m; the EUR notional is set at EUR 230.41m. The company's bond documentation permits hedging but requires that any swap be documented under an ISDA Master Agreement with a CSA. The bank's credit team has set a collateral threshold of USD 10m and a minimum transfer amount of USD 1m. Two years later, EUR/USD is 1.2000 and EUR five-year swap rates are 4.00%. The CFO asks whether the swap has been a good decision and what the current mark-to-market means for liquidity.
1. Map the swap cash flows at inception, annually, and at maturity, and calculate the all-in EUR cost of the funding.
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At inception the company receives USD 250m from the bond issue and, under the swap, exchanges USD 250m for EUR 230.41m: the bank pays EUR and receives USD. The company uses the EUR for its EUR division.
Each year the company pays EUR 230.41m × 3.05% = EUR 7.028m to the bank and receives USD 250m × 5.15% = USD 12.875m from the bank. It also pays the bond coupon of USD 250m × 5.25% = USD 13.125m, so the net USD outflow is USD 0.25m per year.
At maturity the company repays USD 250m to bondholders; under the swap it pays EUR 230.41m to the bank and receives USD 250m, which it uses to repay the bond. The EUR notional is exchanged at maturity at the same 1.0850 rate.
All-in EUR cost: EUR 7.028m plus USD 0.25m converted at 1.0850 (EUR 0.2304m) = EUR 7.258m. Divide by EUR 230.41m to get 3.15%, before fees and collateral costs. The 10bp difference between the 5.25% bond coupon and the 5.15% USD received adds 0.10% to the EUR cost because both notionals are exchanged at the same spot rate.
2. Explain the economic purpose of the swap and why the all-in EUR cost is not simply 3.05%.
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The swap converts the USD fixed liability into a EUR fixed liability, matching the EUR revenue of the division. The 3.05% EUR coupon is not the all-in cost because the company still pays 10bp more on the bond than it receives under the USD leg of the swap (5.25% − 5.15%). That 10bp USD cost, translated into EUR, adds about 0.10%, giving 3.15%. The swap rate also includes a cross-currency basis: the EUR fixed rate is not simply the EUR swap rate plus a credit spread; it reflects USD/EUR basis, liquidity, and the bank's credit charge.
The economic benefit is that the company accesses EUR funding without issuing EUR bonds, and it matches its EUR revenue. But it takes counterparty credit exposure to the bank and collateral obligations under the CSA. The company should compare the all-in 3.15% with a direct EUR bond issue and with a EUR floating-rate exposure, and should check that the hedge is designated and documented for accounting purposes.
3. At the two-year point, explain the direction of the mark-to-market and the collateral/liquidity implications.
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At the two-year point the company pays fixed EUR and receives fixed USD. EUR swap rates have risen from 3.05% to 4.00%, so the fixed EUR payments are below market; the EUR leg has a positive value to the company because it is paying below-market fixed. EUR/USD has risen from 1.0850 to 1.2000, so the EUR notional it must repay is worth more USD; that creates an offsetting loss on the EUR notional in USD terms. The net mark-to-market depends on both, but for a USD-reporting company the swap's USD value is likely negative because the EUR liability has appreciated; the company may have to post collateral above the USD 10m threshold, with a USD 1m minimum transfer amount.
Liquidity risk is real: collateral calls can come when the hedge is economically working but the company's cash is tight. The CFO should distinguish accounting hedge effectiveness from cash collateral needs and stress-test a further 10% EUR move. The company should also confirm the CSA thresholds, eligible collateral, and whether the bank can demand cash at short notice.