Currency Swaps - FS

8/4/2019 Currency Swaps - FS

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F r a n k f u r t S c h o o l . d e

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Basics of CurrencySwaps


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2 F r a n k f u r t S c h o o l . d e

Fundamentals

In its simplest form, a currency swap iseconomically equivalent to an exchange ofinterest and principal payments in onecurrency for interest and principal payments in

another. A currency swap requires that the principalamount is specified in each of the two currenciesinvolved.

The principal is usually exchanged at thebeginning 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. Dr. Sikandar Siddiqui


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Illustration

Dr. Sikandar Siddiqui

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 theyare well known and exchange USD for GBP. Thisresults in exchange rate risk.

OR

They could borrow pounds in the internationalbond market, but pay a lot more in interest thancompanies of comparable credit quality, since they

are not well known abroad.

If Company A can find a company with a mirror-image financing need, both may benefit from aswap.

If the exchange rate is s0

= 1.60 USD/GBP, Company


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The borrowing opportunities for both companiesare given below:

Illustration


$

Company A . %88 . %888

Company B . %888 . %111

In this example, A is rated as being more credit-worthy 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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However, B has a comparative advantage inborrowing in GBP:

The difference in borrowing cost between B andA

- amounts to 2% when borrowing in USD but

- is only 0.4% when borrowing in GBP:

Illustration


$

Company A . %88 . %888

Company B. %888 . %111

Potential Savings = 2.0% - 0.4% = 1.6%


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Therefore, both companies can lower theirinterest expense by

Illustration


- borrowing in the currency where they have acomparative advantage,

- and then entering into a currency swap to

obtain the currency they actually need in thisparticular situation.

$

Company A . %88 . %888

Company B . %888 . %111

Differential (B-A) . %88 . %11


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Illustration


In this example, a specialised intermediary theSwap Bank arranges the transaction and isassumed 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, sothat

- 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%



Illustration


Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

Company

B

i=12%

$

Company A . %88 . %888 Company B . %888 . %111




Illustration


Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

Company

B

i=12%

$

Company A . %88 . %888

Company B . %888 . %111


As net position is to borrow at i=11%

A saves i=0.6%



$

Company A . %88 . %888

Company B . %888 . %111

Illustration


Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

Company

B

i=12%

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

B saves i$=0.6%



Illustration


Company

A

Swap

Bank

i$=8%

i$=8%

i=11%

i=12%

i$=9.4%

Company

B

i=12%

$

Company A . %88 . %888

Company B . %888 . %888

The swap bank makes

money too:

1.4% of $16 millionfinanced with 1% of 10

million per year for 5

years.

At S0 = 1.60 $/, that is a

gain of $64,000 per year

for 5 years.The swap bank

faces exchange raterisk, which it may

or may not choose

to hedge with

another

transaction.



In the absence of credit risk, entering into a currencyswap 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 bonddenominated in

currency Y at face value.

At the end of the swaps tenor, the party underconsideration repays the principal of hypothetical bondissued under (1) and receives the principal of thehypothetical bond bought under (3).

Valuation of Currency Swaps




In terms of currency Y, the calculational market valueof such a swap can thus be determined according tothe following pattern:



=YSwapV ,

Value of

hypothetical bondbought (in units of

the referencecurrency, Y)

Value of

hypothetical bondissued (in units of

currency X)

Spot exchange rate

(price of one unit ofX in terms ofcurrency Y)

VBond, Y VBond, XsY/X-

.





Depending on whether the coupon paymentspertaining to the two components of the swap arefixed or floating, we can distinguish between fourbasic 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-fixedcurrency swaps will beexplicitly dealt with here.



Example: Cash Flow Profile of a Fixed for Fixed

USD/GBP Currency Swap

Key data:

Payment frequency = Semi-annual

Spot rate at inceptions0 = 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 theperspective of the party which has syntheticallyissued GBP debt and invested in USD.


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Example: Cash Flow Profile of a Fixed for Fixed

USD/GBP Currency Swap (continued)



. 0.5 . 100 . (-0.5) . 62.5

Proceeds fromsynthetic GBPbond issuance

Outlay forsynthetic USDbond purchase

Principal + lastcoupon from

synthetic bondinvestment

Principal + lastcoupon from

synthetic bondissue

. 0.5 . 100.

(-0.5).

62.5


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17 F r a n k f u r t S c h o o l . d e Dr. Sikandar Siddiqui


Market values at and after the starting date

At the starting date, the swap described here has amarket value of zero because the values of the USDand the GBP legs cancel out exactly.

During the life of the swap, however, its calculationalmarket value changes because both the currency-specific interest rates and the exchange rate change

over time, and the values of both legs of the swapreact differently to these developments.


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Example: Computation of the calculational market

valueWe now move forward in time and arrive at apoint where

the remaining tenor of the swap is only 2.5 moreyears,

sterling has depreciated to s0.5

= 1.50 USD/GBP,

and

the calculational USD and GBP spot rates,

deduced from thecorresponding par yield curves viabootstrapping, are


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Example: Computation of the calculational market

value


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Example (continued):




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asassumed


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x

=


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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... loses in valueif...

Risk Analysis


currency X declines invalue

the spot interest rates

used to value thesynthetic liability(currency X leg) increase,


used to value the

currency X increases invalue


used to value thesynthetic liability(currency X leg) decline,


used to value the


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Risk Analysis


Impact of a GBP appreciation in the example

An appreciation of the GBP causes thesynthetic liablilty to gain in value, leading to alower 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 syntheticliablilty to lose in value, leading to a higherswap 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 thesynthetic asset to lose in value, leading to alower swap value


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Credit Risks of CurrencySwaps

In the absence of risk mitigation measures likenetting and collateralisation, the counterparties in acurrency swap will be subject to greater credit riskthan in the case of an interest rate swap.

This is due to the fact that in the case of a currencyswap, there is an exchange of principal at the end.

This implies a higher probability of a large buildup invalue, exposing one of the parties (the one which

has been winning) to a correspondingly highpotential loss if other one defaults.


Credit Risks of Swaps d


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Three measures are commonly taken in order to mitigatecounterparty risks

in the field of derivatives trading:

Netting agreements: Claims from different involving thesame 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 contractuallybound to provide collateral in the form of cash or liquid,tradeable securities. Very often, the market value of thecollateral posted is calculationally reduced by a haircutin order to further protect the net creditor againstpotential losses.

Regular mark-to-market valuation: The market values of

ll iti i l d i l l t d l l t

Credit Risks of Swaps andother Derivatives

Documents

Currency Swaps - FS