Page 132 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 9: Swaps

In sterling gain = (10.45 – 11.0)% = (–) 0.55% sterling Notes
Net Gain = (0.65 – 0.55)% = 0.10%
In practice, many currency swaps are arranged with a global bank as the counterparty. Banks
make intermediation profits by charging a fee and/or spread for dealer services. The intermediated
approach reduces the default risk and lowers the search costs that would be present if two
corporations, generally of different nationalities, tried to structure a currency swap directly
between them. The intermediation of currency swaps by global bankers has played a crucial
role in the globalization of the world's financial marketplace.

Notes Interest rate Swaps vs Currency Swaps

The currency swap is closely related to the interest rate swap. There are, however, major
differences in the two instruments. An interest rate swap is an exchange of interest payment
streams of differing character (e.g., fixed rate interest for floating), but in the same currency,
and involves no exchange of principal. The currency swap is in concept an interest rate
swap in more than one currency, and has existed since the 1960s. The interest rate swap
became popular in the early 1980s; it subsequently has become an almost indispensable
instrument in the financial tool box.
Currency swaps come in various forms. One variant is the fixed-for-fixed currency swap,
in which the interest rates on the periodic interest payments of the two currencies are fixed
at the outset for the life of the swap. Another variant is the fixed-for-floating swap, also
called cross currency swap, or currency coupon swap, in which the interest rate in one
currency is floating (e.g., based on LIBOR) and the interest rate in the other is fixed. It is
also possible to arrange floating-for floating currency swaps, in which both interest rates
are floating.
The major difference is that with a currency swap, there is always an exchange of principal
amounts at maturity at a predetermined exchange rate. Thus, the swap contract behaves
like a long-dated forward foreign exchange contract, where the forward rate is the current
spot rate.
According to interest rate parity theory, forward rates are a direct function of the interest
rate differential for the two currencies involved. As a result, a currency with lower interest
rate has a correspondingly higher forward exchange value. It follows that future exchange
of currencies at the present spot exchange rate would offset the current difference in
interest rates. This exchange of principals is what occurs in every currency swap at maturity
based on the original amounts of each currency and, by implication, done at the original
spot exchange rate.
Currency swaps are often combined with interest rate swaps. For example, one company
would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a
floating-rate debt denominated in Euro. This is especially common in Europe where
companies "shop" for the cheapest debt regardless of its denomination and then seek to
exchange it for the debt in desired currency.

Self Assessment

Fill in the blanks:

10. Currency swaps are derivative products that help to manage exchange rate and
………….exposure on long-term liabilities.

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