Acquired cross currency swap

What Is Acquired Cross-Currency Swap?

An Acquired Cross-Currency Swap refers to the situation where a company obtains existing cross-currency swap contracts as part of a merger or acquisition (M&A) transaction. Rather than being a distinct financial instrument, it highlights the need for thorough analysis and integration of pre-existing derivative positions into the acquiring entity's overall financial management strategy. These acquired contracts fall under the broader category of derivatives and are a critical aspect of corporate finance, particularly within risk management. When an acquisition occurs, the acquiring firm inherits the rights and obligations of the target company's existing cross-currency swaps, which are financial agreements to exchange principal and interest payments in different currencies.

History and Origin

The concept of a cross-currency swap, from which an Acquired Cross-Currency Swap originates, has roots in the evolution of international finance. Currency swaps themselves emerged in the late 1970s and early 1980s, driven by market participants seeking to circumvent foreign exchange controls and exploit comparative borrowing advantages across different national markets. Early forms of these arrangements were known as "back-to-back" or "parallel loans" used to bypass restrictions, particularly by UK companies seeking dollar loans during the 1970s.¹⁴ Over time, these informal arrangements evolved into more structured over-the-counter (OTC) derivative contracts. The Bank for International Settlements (BIS) has tracked foreign exchange and OTC derivatives markets since 1986, indicating the growing importance and formalization of these instruments in global finance.¹³,¹² Central banks also developed currency swap networks, for instance, a network created by the G10 central banks from 1961 to manage international monetary stability.¹¹ The integration of cross-currency swaps into corporate structures and the subsequent challenges of their acquisition have become more prominent as global M&A activity increased.

Key Takeaways

• An Acquired Cross-Currency Swap signifies a company inheriting existing cross-currency swap contracts through a merger or acquisition.
• It requires the acquiring company to assess and manage the associated foreign exchange risk and interest rate risk.
• Thorough due diligence is crucial to understand the terms, risks, and fair value of these acquired derivatives.
• Integration of these swaps into the acquirer's existing hedging strategy and corporate treasury operations is essential.
• Acquired Cross-Currency Swaps can impact the combined entity's balance sheet, cash flow, and overall financial stability.

Formula and Calculation

While there isn't a specific formula for an "Acquired Cross-Currency Swap" as it refers to a state rather than a calculation, understanding the underlying cross-currency swap involves specific calculations. A cross-currency swap is an agreement between two parties to exchange equivalent amounts of principal in different currencies at the outset and at maturity, and to exchange interest payments on the respective principal amounts over the life of the swap.

The initial exchange of principal (at time (t=0)) is typically at the spot exchange rate:

[
P_A \times S_0 = P_B
]

Where:

• (P_A) = Principal amount in Currency A
• (P_B) = Principal amount in Currency B
• (S_0) = Spot exchange rate (units of Currency B per unit of Currency A)

Periodic interest payments are exchanged based on agreed-upon interest rates (fixed or floating) and the notional principal amounts. For example, if Party A pays fixed interest on Currency B and receives floating interest on Currency A:

Payment from Party A to Party B:
[
\text{Interest}_B = P_B \times \text{Fixed Rate}_B \times \text{Days}/360
]

Payment from Party B to Party A:
[
\text{Interest}_A = P_A \times \text{Floating Rate}_A \times \text{Days}/360
]

At maturity, the principal amounts are re-exchanged, often at the initial spot rate to eliminate currency exposure on the principal.

Interpreting the Acquired Cross-Currency Swap

When a company acquires an existing cross-currency swap, the interpretation centers on its financial implications for the combined entity. The key is to understand the swap's current market value, often referred to as its mark-to-market (MTM) value. If the acquired swap has a positive MTM, it represents an asset to the acquirer; if negative, it's a liability. This value is influenced by changes in exchange rates and interest rate differentials since the swap's inception.

Furthermore, the acquiring company must evaluate how the Acquired Cross-Currency Swap fits into its existing hedging strategy. Does it align with the new consolidated currency exposure or create new, unintended risks? The nature of the interest rate payments (fixed or floating) also needs to be assessed in the context of the acquirer's interest rate risk profile. A comprehensive review allows the corporate treasury function to decide whether to maintain, restructure, or terminate the acquired position.

Hypothetical Example

Consider Tech Solutions Inc., a U.S.-based technology company, which acquires EuroCorp, a European manufacturing firm. As part of the acquisition, Tech Solutions Inc. inherits EuroCorp's outstanding cross-currency swap agreement. This swap involves EuroCorp paying fixed interest in EUR and receiving floating interest in USD, with an initial notional principal exchange of EUR 50 million for USD 60 million when the spot rate was 1.20 USD/EUR. The swap has three years remaining.

Upon acquisition, the spot rate has shifted to 1.10 USD/EUR, and the interest rate environment has also changed. Tech Solutions Inc. now needs to analyze this Acquired Cross-Currency Swap. They determine that because the EUR has depreciated against the USD, and EuroCorp was paying in EUR, the swap has become more favorable for the side receiving USD, potentially resulting in a positive mark-to-market value for Tech Solutions Inc. Conversely, the initial exchange of principals means Tech Solutions Inc. inherited the obligation to re-exchange the principals at the original rate, which could lead to a loss on the principal re-exchange if the exchange rate remains at 1.10 USD/EUR at maturity. The financial management team at Tech Solutions Inc. must decide if this particular cross-currency swap continues to serve a strategic hedging purpose for their newly combined entity, or if it introduces unwanted currency exposure that needs to be addressed.

Practical Applications

Acquired Cross-Currency Swaps frequently appear in global mergers and acquisitions where target companies operate across multiple jurisdictions and have utilized derivatives for risk management.

• M&A Due Diligence: During the due diligence phase of an acquisition, identifying and valuing all existing financial instruments, including cross-currency swaps, is paramount. This process helps the acquiring company understand the true financial position of the target and the potential impact on its own balance sheet.
• Post-Acquisition Integration: After an acquisition, the acquiring firm's corporate treasury department integrates the acquired cross-currency swaps into the consolidated hedging program. This might involve novating the contracts to the acquiring entity, renegotiating terms with counterparties, or terminating the swaps if they no longer align with the combined company's risk profile.
• Financing Overseas Operations: Companies often use cross-currency swaps to manage the currency exposure associated with financing foreign subsidiaries or investments. An Acquired Cross-Currency Swap may relate to such existing financing arrangements within the acquired entity. Corporate financial hedging, including the use of derivatives, can facilitate access to external capital markets and influence financing choices in M&A deals.¹⁰,⁹ For instance, deal-contingent hedges are a type of derivative used in M&A that lock in financing costs or forward exchange rates, expiring without cost if the deal fails.⁸,⁷
• Regulatory Compliance: The acquisition of cross-currency swaps also triggers regulatory considerations. Post-2008 financial crisis regulations, such as the Dodd-Frank Act in the United States, significantly increased oversight of the over-the-counter (OTC) derivatives market, including swaps.⁶,⁵ The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) now regulate different types of swaps.⁴,³ Acquired swap positions must comply with these rules regarding clearing, execution, and reporting.

Limitations and Criticisms

Acquiring existing cross-currency swaps comes with inherent limitations and potential criticisms that must be carefully considered.

One primary concern is the exposure to counterparty risk. An Acquired Cross-Currency Swap means inheriting the credit risk of the original swap counterparty. If that counterparty defaults, the acquiring company could face significant financial losses, particularly for long-term swaps where the counterparty's creditworthiness might deteriorate over time. This risk is amplified because cross-currency swaps are typically traded over-the-counter (OTC), meaning they are bilateral agreements not traded on exchanges, which can increase the opacity and reduce the liquidity of these positions.

Another limitation stems from potential mismatches in hedging strategies. The acquired swap might have been perfectly tailored for the target company's standalone currency exposure but could create new, undesired exposures or concentrations for the combined entity. For example, an acquired swap designed to hedge a specific foreign currency asset might become redundant or even detrimental if the acquirer's existing balance sheet already naturally hedges that exposure.

Furthermore, unwinding or restructuring an Acquired Cross-Currency Swap can be complex and costly, especially if market conditions have moved unfavorably since the swap's inception. While cross-currency swaps are valuable for managing foreign exchange risk and funding costs, their effective use requires careful management of risks such as interest rate fluctuations, liquidity risk, and basis risk (mismatches between interest rate benchmarks). Some research suggests that cross-currency basis swaps between certain economies may not always serve as effective currency hedges, indicating a need for thorough assessment of exchange rate trajectories and associated risks.²,¹

Acquired Cross-Currency Swap vs. Cross-Currency Swap

The distinction between an Acquired Cross-Currency Swap and a standard cross-currency swap lies in the context of their origination and ongoing management.

Essentially, a standard cross-currency swap is a financial contract created to achieve specific foreign exchange and interest rate risk management objectives. An Acquired Cross-Currency Swap, however, refers to the managerial and strategic challenges that arise when such a contract is inherited rather than initiated, requiring a post-acquisition evaluation of its continued relevance and impact on the combined entity's financial management.

FAQs

What does "Acquired" mean in this context?

In the context of an Acquired Cross-Currency Swap, "acquired" means that an existing cross-currency swap contract, originally entered into by a target company, becomes the responsibility of the acquiring company following a merger or acquisition. The acquiring firm inherits all the rights and obligations associated with that financial instrument.

Why is an Acquired Cross-Currency Swap important to identify during M&A?

It is important to identify an Acquired Cross-Currency Swap during mergers and acquisitions because these contracts can carry significant foreign exchange risk or interest rate risk. Their fair value can impact the acquisition price and the combined entity's future cash flow and financial performance. Thorough due diligence helps in assessing these financial liabilities or assets.

Can an Acquired Cross-Currency Swap be terminated?

Yes, an Acquired Cross-Currency Swap can often be terminated or restructured, but typically with associated costs or benefits, depending on the prevailing market conditions and the swap's current mark-to-market value. The acquiring company's corporate treasury team will evaluate the economic impact of such actions.

What are the main risks associated with an Acquired Cross-Currency Swap?

The main risks include counterparty risk, where the original counterparty to the swap defaults on its obligations; market risk, due to adverse movements in exchange rates or interest rates; and operational risk related to the integration and management of the acquired derivative into the new corporate structure.

How does an Acquired Cross-Currency Swap impact a company's balance sheet?

An Acquired Cross-Currency Swap impacts a company's balance sheet by being recorded at its fair value. If the swap has a positive fair value, it will be recognized as an asset; if it has a negative fair value, it will be recognized as a liability. Changes in this fair value over time are typically recorded in earnings or other comprehensive income, depending on the accounting treatment for derivative instruments.