Creating Foreign-Currency Bond Exposure with Cross-Currency Swaps

Summary

The document explains how a bond’s cash flows can be converted into another currency using a cross-currency swap. An investor could hold a fixed-coupon U.S. Treasury and exchange its expected dollar payments for payments in a foreign currency, creating foreign-currency bond-like economics. A cross-currency asset swap is presented as a practical route; a series of exchange-traded FX futures is unlikely to match bond coupon dates exactly because futures have standardized maturities.

The discussion distinguishes economic exposure from owning a bond legally denominated in the target currency. An institution that must hold such a bond may need a special-purpose vehicle to buy the original bond, enter the swap, and issue the desired currency bond, adding costs. If the underlying bond carries credit risk, default may leave the swap outstanding; a “perfect” asset swap can terminate on default, but is more expensive. The explanation is conceptual and does not quantify pricing, collateral, basis, liquidity, or counterparty risks, so it is not a complete implementation or valuation guide.

Key ideas

• Cross-currency swaps can convert a bond’s coupons and principal into payments in another currency.
• Standardized FX futures dates are unlikely to replicate a bond’s coupon schedule exactly.
• A synthetic foreign-currency exposure may not satisfy requirements to legally own a bond denominated in that currency.
• A special-purpose vehicle can issue a target-currency bond backed by a bond and swap, with added costs.
• Credit risk can leave an asset swap exposed after the underlying bond defaults; default-terminating structures cost more.

Tags

# Synthetic bonds with FX futures


# Synthetic bonds with FX futures












FX futures price in the interest rate of different currencies, so can you use US treasury bonds (for example /zn) and FX futures (for example SGX USD/CNH FX Future) to create a synthetic bond of a foreign currency?

## Answer by Dimitri Vulis (score 5)

https://quant.stackexchange.com/a/65905

Because exchahnge-traded FX futures have standard monthly dates, it's very unlkely that you can use FX futures to replicate exactly the bond's coupons. However you can use a series of OTC FX forwards or a cross-currency swap to swap some bond's coupons into another currency (fixed or floating). Look up "cross-currency asset swap". For example, you can buy some U.S. treasury debt paying a fixed USD coupon and principal, and enter into a cross-currency swap where you pay the USD amounts that you expect to receive from U.S. treasury and receive some GBP amounts (as an example, or some other foreigh currency). But does this portfolio constitute a GBP-denominated bond?

From some economic standpoint, yes, it already does. But if you're a highly regulated insurance company, for example, and you actually need to own a GBP-denominated bond, not a synthetic one, then you'd need to jump through additional hoops. You'd need some bank to set up a special purpose vehicle (SPV). The SPV will buy the original bond, enter into a cross-currency swap, and issue the GBP bond that you desire. All these labor-intensive services end up being paid for by the bondholder, of course.

And what if the USD bond is not U.S. Treasury, but has credit risk? If the bond defaults, are you still going to be stuck with the cross-currency swap? There is a variation of an asset swap called "perfect" asset swap, which terminates if the bond defaults, but it costs more.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.