How do cross-currency swaps actually work, and why is the notional exchanged unlike regular interest rate swaps?

Cross-currency swaps are fundamentally different from plain IRS because they involve two different currencies, so netting the notional makes no sense — you need actual delivery of each currency.

Structure:

At inception, two parties agree to:

1. Exchange notionals at the current spot rate (e.g., $100M for EUR 92M at 1.0870)
2. Swap interest payments periodically — Party A pays USD floating (SOFR), Party B pays EUR fixed (say 2.5%)
3. Re-exchange notionals at maturity at the original exchange rate (not the prevailing rate)

Example: Pinnacle Industries (US) vs. Vanguard Handel AG (Germany)

Pinnacle needs EUR funding; Vanguard needs USD. Instead of each borrowing in a foreign market at unfavorable rates, they do a 5-year cross-currency swap:

Mid-Life Valuation:

To value the swap mid-life, treat it as two bonds:

• USD leg: PV of remaining USD cash flows (discounted at USD rates)
• EUR leg: PV of remaining EUR cash flows (discounted at EUR rates), converted to USD at current spot

Value to Pinnacle = PV(EUR leg in USD) - PV(USD leg)

If the EUR has appreciated since inception, Pinnacle benefits because they locked in the original exchange rate for the final notional exchange — they'll return EUR at a cheaper rate than the market.

Key FRM Points:

• Notional exchange creates significant FX risk at maturity
• Unlike IRS, cross-currency swaps have meaningful credit exposure due to notional exchange
• Central clearing is less common, so bilateral credit risk matters
• Mark-to-market swings can be large when exchange rates are volatile

Dive deeper into swap mechanics in our FRM Part I course.