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 Forum Navigation: StudentForum new topic search bookshop news help file share audio visual articles blogs wiki forums home login FORUMS > Student Forum < refresh > Topic Title: Cross currency swap conundrum Created On Thu May 11, 06 12:39 PM Topic View: Linear  skphang Member Posts: 141 Joined: Jul 2002 Thu May 11, 06 12:39 PM I never thought I'd be asking this question, but here goes... Looking at papers and textbooks regarding the valuation of cross currency swaps, there are 2 standard methods: (1) PV(swap flows in home country) - spot exchange rate x PV(swap flows in foreign country), where PV is done with the treasury zero rates of the respective countries (2) PV(swap flows in home country - swap flows in foreign country x forward rates), where PV is done with the treasury zero rates of the home country However, the concept of present value (if I understand correctly), is the use of a discount rate that represents the cost of borrowing. If I look at cross currency swaps as a means of borrowing foreign currency, then I should be charged something above the treasury zero rate in the foreign country to compensate the foreign counterparty for country risk. In other words, a spread should be added to foreign treasury zero rate when calculating PV(swap flows in foreign country) in (1). This would be especially true if my country's sovereign rating is many notches below the rating of the foreign counterparty. Is this correct? If so, how does one calculate this country risk spread? Thanks very much. Reply Quote Top Bottom Geist Member Posts: 161 Joined: May 2003 Thu May 11, 06 02:04 PM Quote Originally posted by: skphang  I never thought I'd be asking this question, but here goes... Looking at papers and textbooks regarding the valuation of cross currency swaps, there are 2 standard methods: (1) PV(swap flows in home country) - spot exchange rate x PV(swap flows in foreign country), where PV is done with the treasury zero rates of the respective countries (2) PV(swap flows in home country - swap flows in foreign country x forward rates), where PV is done with the treasury zero rates of the home country However, the concept of present value (if I understand correctly), is the use of a discount rate that represents the cost of borrowing. If I look at cross currency swaps as a means of borrowing foreign currency, then I should be charged something above the treasury zero rate in the foreign country to compensate the foreign counterparty for country risk. In other words, a spread should be added to foreign treasury zero rate when calculating PV(swap flows in foreign country) in (1). This would be especially true if my country's sovereign rating is many notches below the rating of the foreign counterparty. Is this correct? If so, how does one calculate this country risk spread? Thanks very much. Yes, that's correct. The difference is in fact traded and is called the currency basis . It's quoted as a spread over 3m Libor (e.g. 3m Lib flat vs 3m JPY Libor -x bps). This basis is essentialy another way of expressing the FX fwd rates and represents the cost of funding in one ccy vs investing in another ccy. Reply Quote Top Bottom skphang Member Posts: 141 Joined: Jul 2002 Fri May 12, 06 04:34 AM Thanks! Just to see if I understand correctly, if the FX forward points are negative, i.e. there is an expectation of strong currency appreciation in the non-US country, then it is actually cheaper to borrow USD in the non-US country than in the US itself? In other words, the currency gains outweigh the country risk, so the non-US country ends up paying less? Edited: Fri May 12, 06 at 05:02 AM by skphang Reply Quote Top Bottom Mon May 15, 06 09:44 AM Page 1 of 2 Wilmott Forums - Cross currency swap conundrum 5/11/2011 http://www.wilmott.com/messageview.cfm?catid=8 &threadid=3840 6

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skphang Member

Posts: 141

Joined: Jul 2002 

Thu May 11, 06 12:39 PM

I never thought I'd be asking this question, but here goes...

Looking at papers and textbooks regarding the valuation of cross currency swaps, there are 2 standard methods:(1) PV(swap flows in home country) - spot exchange rate x PV(swap flows in foreign country), where PV is done with thetreasury zero rates of the respective countries(2) PV(swap flows in home country - swap flows in foreign country x forward rates), where PV is done with the treasuryzero rates of the home country

However, the concept of present value (if I understand correctly), is the use of a discount rate that represents the cost ofborrowing. If I look at cross currency swaps as a means of borrowing foreign currency, then I should be chargedsomething above the treasury zero rate in the foreign country to compensate the foreign counterparty for country risk. In

other words, a spread should be added to foreign treasury zero rate when calculating PV(swap flows in foreign country)in (1). This would be especially true if my country's sovereign rating is many notches below the rating of the foreigncounterparty.

Is this correct? If so, how does one calculate this country risk spread?

Thanks very much.

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Geist 

Member

Posts: 161Joined: May 2003 

Thu May 11, 06 02:04 PM

Quote

Originally posted by: skphang  I never thought I'd be asking this question, but here goes...

Looking at papers and textbooks regarding the valuation of cross currency swaps, there are 2 standardmethods:(1) PV(swap flows in home country) - spot exchange rate x PV(swap flows in foreign country), where PVis done with the treasury zero rates of the respective countries(2) PV(swap flows in home country - swap flows in foreign country x forward rates), where PV is donewith the treasury zero rates of the home country

However, the concept of present value (if I understand correctly), is the use of a discount rate thatrepresents the cost of borrowing. If I look at cross currency swaps as a means of borrowing foreigncurrency, then I should be charged something above the treasury zero rate in the foreign country tocompensate the foreign counterparty for country risk. In other words, a spread should be added to foreigntreasury zero rate when calculating PV(swap flows in foreign country) in (1). This would be especially trueif my country's sovereign rating is many notches below the rating of the foreign counterparty.

Is this correct? If so, how does one calculate this country risk spread?

Thanks very much.

Yes, that's correct. The difference is in fact traded and is called the currency basis . It's quoted as a spread over 3mLibor (e.g. 3m Lib flat vs 3m JPY Libor -x bps). This basis is essentialy another way of expressing the FX fwd rates andrepresents the cost of funding in one ccy vs investing in another ccy.

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skphang 

Member

Posts: 141

Joined: Jul 2002 

Fri May 12, 06 04:34 AM

Thanks!

Just to see if I understand correctly, if the FX forward points are negative, i.e. there is an expectation of strong currencyappreciation in the non-US country, then it is actually cheaper to borrow USD in the non-US country than in the USitself? In other words, the currency gains outweigh the country risk, so the non-US country ends up paying less?

Edited: Fri May 12, 06 at 05:02 AM by skphang Reply  Quote  Top  Bottom 

Mon May 15, 06 09:44 AM

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caroe 

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Posts: 123

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The currency basis reflects counterparty risk rather than currency risk, namely the credit quality of the banks quotingLIBOR. Currency basis has historically been high for Dollar-Yen basis swaps (or Dollar-Norwegian Krone basis swapsfor that matter), reflecting the superior credit quality of banks quoting US Libor versus that of (Japanese) banks quotingJPY Libor

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skphang Member

Posts: 141

Joined: Jul 2002 

Tue May 16, 06 04:29 PM

Ok... I think I understand the currency basis. However, the basis affects the rates applied to the notionals. My question isabout the discount curve used to find the present value of cash flows.

Let's say that I am an 'A-' rated bank in an emerging market country that swaps the local currency for USD with an 'AA'bank whose parent is incorporated in the United States.

What discount curve does the 'AA' bank use to discount the cash coming from the 'A-' bank?

Does the 'AA' bank use only a typical 'A-' credit curve, or does it add a country risk spread to the curve as well?

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