Let's say I've bond is USD with a maturity of 25yrs and yield of 5% and coupon 7%, but I'm located in Europe and wanna hedge the USD risk, How can I use cross currency swap to do this ?
Aligning your bond's cashflows with the CCS cashflows timing-wise, you would look to pay fixed USD 7% on one leg and on the other leg either
- (a) receive fixed EUR (fix-fix CCS), or
- (b) receive float EUR, like EURIBOR or ESTR plus a spread (fix-float CCS).
NB: this is a bit simplifying and you should of course also think of the bond notional redemption at maturity + take into consideration notional exchanges at the start/end of the xccy swap as well as nominal resets on itself. It can be a bit more challenging to align all of these in practice, especially if you do not do it on a stand-alone basis for this very bond, but rather a whole book of fixed income products.
If you have not already purchased the USD bond, you would enter into the following cross currency swap:
Purchase the amount of USD (vs EUR) using the dirty price (clean price + accrued interest) required to settle the bond purchase.
Sell USD (vs EUR) for each coupon (in the US typically semi annually using the day count convention for your bond, in your case 7%/2 sa) and the principal at maturity (the maturity will typically have one coupon + the notional amount) to settle on the dates when you would receive them.
Technically the above is not a currency swap as the market would know it since there are interim Sell USD Buy EUR forwards in the periods between the purchase date and the maturity date of the bond. However, any dealer can price this for you and package it up into a swap.
If you already have the bond and are looking to hedge, just do leg 2 described above. Sell USD forward where the value date is on each of the coupon and maturity dates.
The rates you would use to sell the USD will be determined by the USD and the EUR yield curves on the day you trade.
If the bond is a US treasury instrument and you can assume that it has no credit risk, then you hedge the cash flows as other answers described - an FX forward for each expected cash flow (bond interest and principal payments), or a cross-currency swap whose USD leg matches the bond, or an asset swap. Note that if you receive fixed EUR, then you have EUR interest rate risk that you probably want to hedge as well.
But if your USD bond has credit risk, then you have 3 risks:
- FX rate
- USD interest rate
- bond issuer's credit risk
Moreover the credit risk has 2 separate pieces: the LGD, the loss if the bond defaults; and credit01/cs01/cr01, the change in your bond's mark to market if the credit spread changes 1 basis point, if you're marking to market the bond (trading book or fair value option of banking book). You can't hedge them all at all, let alone statically. If the bond defaults, then you're stuck with the FX and IR hedge (such as the asset swap) that you no longer need.
One possible dynamic hedging approach is that since you're long the credit now, you buy CDS protection (note that you trade 5Y protection because no one trades 25Y CDS anymore) to flatten the credit01 to a comfortable level; and get less cross-currency swap, weighing the bond's cash flows by its probability of survival. As time passes and credit spread changes, you recalculate your credit01, fx delta, and interest rate risk, and if they are more than you want, then you re-adjust the hedges to flatten your risks to comfortable levels. You will not be flat LGD, and you will have tenor mismatch in your credit01, but hopefully you will be able to unwind everything before the bond gets close to actually defaulting. You can run a monte-carlo simulation with conservative transacton cost assumptions to estimate how much this can cost. Note that your accounting rules may not allow your dynamic hedges to be called hedges.