Basics of Currency Swaps

Akademische Programme Berufsbegleitende Programme Seminare Executive Education Unternehmensprogramme & Services Forschung Internationale Beratung
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Fundamentals
In its simplest form, a currency swap is economically equivalent to an exchange of interest and principal payments in one currency for interest and principal payments in another. A currency swap requires that the principal amount is specified in each of the two currencies involved. The principal is usually exchanged at the beginning and at the end of the swap. Usually, the principal amounts are chosen to be (almost) equivalent, using the exchange rate prevailing at the initiation of the swap.
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Illustration
Suppose a U.S. company A, wants to finance a 10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange USD for GBP. This results in exchange rate risk. OR They could borrow pounds in the international bond market, but pay a lot more in interest than companies of comparable credit quality, since they are not well known abroad. If Company A can find a company with a mirrorimage financing need, both may benefit from a swap.
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If the exchange rate is s0 = 1.60 USD/GBP, Company Dr. Sikandar Siddiqui

Illustration
The borrowing opportunities for both companies are given below: $ 8 % 8.8 .8 8% Company A 8.8 1.1 8% 1% Company B In this example, A is rated as being more creditworthy by the market than B: - A pays 2% less to borrow in dollars than B. - A pays 0.4% less to borrow in pounds than B.

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Illustration
However, B has a comparative advantage in borrowing in GBP: The difference in borrowing cost between B and A - amounts to 2% when borrowing in USD but $ - is only 0.4% when borrowing in GBP:

Company A Company B

8% .8 8.8 8%

8.8 8% 1.1 1%
= 1.6%

Potential Savings = 2.0% - 0.4%

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Illustration
Therefore, both companies can lower their interest expense by - borrowing in the currency where they have a comparative advantage, - and then entering into a currency swap to obtain the currency they actually need in this particular situation.
$ Company A Company B Differential (B-A) 8% .8 8.8 8% 8% .8 8.8 8% 1.1 1% 1% .1

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Illustration
In this example, a specialised intermediary the Swap Bank arranges the transaction and is assumed to claim an amount equivalent to 0.4% for itself as a compensation for this service. The remaining part of the total advantage (1.6% 0.4% = 1.2%) is split equally between A and B, so that - Company A pays 11.6% - 0.5 x 1.2% = 11.0%, and - Company B pays 10.0% - 0.5 x 1.2% = 9.4%
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Illustration
Swap Bank i$=8% i$=8% Company A i=11% i$=9.4% i=12% Company i=12% B
8. 8 8% 1. 1 1% 1% .1

$ Company A Company B Differential (B-A) 8% .8 8. 8 8% 8% .8

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Illustration
Swap Bank i$=8% i$=8% Company A i=11% i$=9.4% i=12% Company i=12% B
$ Company A Company B Differential (B -A) 88 . % 8. % 88 88 . % 8. % 88 1. % 11 11 . %

As net position is to borrow at i=11% A saves i=0.6%

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Illustration
Swap Bank i$=8% i$=8% Company A
$ Company A Company B 8% .8 8.8 8% 8. % 8 8 1. % 1 1

i$=9.4% i=12% Company i=12% B

i=11%

Bs net position is to borrow at i$=9.4% B saves i$=0.6%

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Illustration
The swap bank makes money too: i$=8% i$=8% Company A Swap Bank i=12% i=11% At S0 = 1.60 $/, that is a gain of $64,000 per year for 5 years.
$ Company A Company B 8% .8 8.8 8% 8. % 8 8 8. % 8 8

i$=9.4%

1.4% of $16 million financed with 1% of 10 million per year for 5 years.

Company i=12% B
The swap bank faces exchange rate risk, which it may or may not choose to hedge with another transaction.
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Valuation of Currency Swaps

In the absence of credit risk, entering into a currency swap is economically equivalent to simultaneously (1) issuing a bond in currency X (e.g. GBP) at par (2) exchanging the proceeds from (1) into currency Y (e.g. USD) at the spot exchange rate, and (3) using the proceeds from (2) to buy a bond denominated in currency Y at face value. At the end of the swaps tenor, the party under consideration repays the principal of hypothetical bond issued under (1) and receives the principal of the hypothetical bond bought under (3).
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Valuation of Currency Swaps

In terms of currency Y, the calculational market value of such a swap can thus be determined according to the following pattern:
Spot exchange rate (price of one unit of X in terms of currency Y)

VSwap , Y = VBond, Y
Value of hypothetical bond bought (in units of the reference currency, Y)

sY/X

VBond, X
Value of hypothetical bond issued (in units of currency X)

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Valuation of Currency Swaps

Depending on whether the coupon payments pertaining to the two components of the swap are fixed or floating, we can distinguish between four basic types of currency swaps: - fixed for fixed, - fixed for floating, - floating for fixed, and - floating for floating. For the sake of simplicity, only fixed-for-fixed currency swaps will be explicitly dealt with here.
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Valuation of Currency Swaps

Example: Cash Flow Profile of a Fixed for Fixed USD/GBP Currency Swap Key data: Payment frequency = Semi-annual Spot rate at inception s0 = 1.60 USD/GBP, Face value = USD 100 = GBP 62.5 (= 100/1.60) Term = 3 years. Fixed swap rate (USD) = 1.43% Fixed swap rate (GBP) = 2.21%

As before, we describe the situation from the perspective of the party which has synthetically issued GBP debt and invested in USD.
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Valuation of Currency Swaps

Example: Cash Flow Profile of a Fixed for Fixed USD/GBP Currency Swap (continued)
Outlay for synthetic USD bond purchase Proceeds from synthetic GBP bond issuance

0.5 . 100

(-0.5) . 62.5

0.5 . 100

(-0.5) . 62.5

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Principal + last coupon from synthetic bond investment

Principal + last coupon from synthetic bond issue

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Valuation of Currency Swaps

Market values at and after the starting date At the starting date, the swap described here has a market value of zero because the values of the USD and the GBP legs cancel out exactly. During the life of the swap, however, its calculational market value changes because both the currencyspecific interest rates and the exchange rate change over time, and the values of both legs of the swap react differently to these developments.

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Valuation of Currency Swaps

Example: Computation of the calculational market value move forward in time and arrive at a We now point where the remaining tenor of the swap is only 2.5 more years, sterling has depreciated to s0.5 = 1.50 USD/GBP, and the calculational USD and GBP spot rates, deduced from the corresponding par yield curves via bootstrapping, are

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Valuation of Currency Swaps

Example: Computation of the calculational market value

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

as assumed

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Valuation of Currency Swaps

Example (continued):

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Risk Analysis
A currency swap thus consists of a synthetic liability in one currency (currency X) and an (initially equally valued) asset in another (currency Y). It thus gains in value if... currency X declines in if... value the spot interest rates used to value the synthetic liability (currency X leg) increase, the spot interest rates used to value the FrankfurtSchool.de

currency X increases in loses in value value the spot interest rates used to value the synthetic liability (currency X leg) decline, the spot interest rates used to value the Dr. Sikandar Siddiqui

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Risk Analysis
Impact of a GBP appreciation in the example

An appreciation of the GBP causes the synthetic liablilty to gain in value, leading to a lower swap value

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Risk Analysis
Impact of an increase in GBP spot interest rates in the example

Higher GBP spot rates cause the synthetic liablilty to lose in value, leading to a higher swap value

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Risk Analysis
Impact of an increase in USD spot interest rates in the example

Higher USD spot interest rates cause the synthetic asset to lose in value, leading to a lower swap value

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Credit Risks of Currency Swaps

In the absence of risk mitigation measures like netting and collateralisation, the counterparties in a currency swap will be subject to greater credit risk than in the case of an interest rate swap. This is due to the fact that in the case of a currency swap, there is an exchange of principal at the end. This implies a higher probability of a large buildup in value, exposing one of the parties (the one which has been winning) to a correspondingly high potential loss if other one defaults.

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Credit Risks of Swaps

other Derivatives

and

Three measures are commonly taken in order to mitigate counterparty risks in the field of derivatives trading: Netting agreements: Claims from different involving the same counterparties are counted up against each other, and only the net amount is actually paid when due. Collateralisation: The particular counterparty which currently is in the position of a net debtor is contractually bound to provide collateral in the form of cash or liquid, tradeable securities. Very often, the market value of the collateral posted is calculationally reduced by a haircut in order to further protect the net creditor against potential losses. Regular mark-to-market valuation: The market values of all positions in-volved is re-calculated regularly to ensure Dr. Sikandar Siddiqui FrankfurtSchool.de that the information on counter-party credit exposures

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