Chapter 5
Foreign Exchange Swaps
Foreign Exchange Swaps
• OTC contract
• FX swap is interpreted as a spot-forward swap
• Two counterparties agree to a forward trade (on a notional amount of one of
the two currencies) and an offsetting (opposite) spot transaction (typically on
the same notional amount of that currency)
Foreign Exchange Swaps
• Since the forward trade changes the FX risk for the quoting bank, the
associated (opposite and offsetting) spot trade reduces risk for the market
maker to basis risk or carry risk (i.e., interest rate risk).
• In essence, this FX forward trade is turned into an interest rate trade, and
often FX forwards and FX swaps are managed by the “cash” or interest rate
desks at the banks that make markets in this area.
Basic Foreign Exchange Swaps
•
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
• US based company wan raise “cheap” USD 100,000,000.
• Issue bond in Swiss worth CHF 125,000,000 @ 2.500% , 5 years bond
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
•
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
• Because a cross-currency swap, as described above, often accompanies a
bond issue in another country/currency, it is sometimes called a “bond
swap”; the real reason, though, that a cross-currency swap is referred to as a
bond swap is that it looks like the exchange of a par bond in one currency
for a spot-equivalent-amount of another par bond in another currency.
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
• If the U.S. corporation really wanted floating rate (i.e., LIBOR) USD debt, they could have
simply layered a standard fixed-for-floating USD interest rate swap on top of the
fixed-for-fixed cross-currency swap. This need not have even required another transaction
(as the providers of cross-currency swaps generally also provide interest rate swaps).
• One can do fixed USD-for-fixed CHF cross-currency swaps, floating USD-for fixed CHF
cross-currency swaps, fixed USD-for-floating CHF cross-currency swaps, and floating
USD-for-floating CHF cross-currency swaps.
• This last swap might not seem fair as USD interest rates are higher than CHF interest
rates, but, looked at today, as a snapshot, with the expected appreciation of the Swiss
Franc (as built into the forward rates), the net present value of the swap (when reduced to
either currency today) is zero. In a floating-for-floating cross-currency swap, it’s the case
that (USD) LIBOR should “swap” for (CHF) LIBOR, regardless of the fact that these
rates may be of different orders of magnitude.
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
• Since the U.S. corporation in our example really just wanted cheap Dollars,
but actually received CHF (upon issuing the fixed coupon CHF-denominated
bond in Switzerland), they would want to do an up-front spot exchange.
Using the numbers from our example, they would want to trade in the CHF
125,000,000 and receive USD 100,000,000.
• On the other hand, if the U.S. corporation wanted to open a new branch in
Switzerland (and needed CHF to do so), they would likely not do the
CHF-USD spot exchange.
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
• While these are OTC contracts and are typically done at “fair value,” that is,
at the coupon rates that make any up-front cash payment by either
counterparty unnecessary, once entered into, a cross-currency swap can and
generally will take on a positive or negative value.
• As USD|CHF spot moves and Swiss and U.S. interest rates change, the
mark-to-market value of this swap will change. In short, these swaps have
market risk and credit risk.
CROSS-CURRENCY SWAPS OR FX CROSS-CURRENCY
INTEREST RATE SWAPS OR FX BOND SWAPS
• One way to mitigate this asymmetry and the associated cumulating
counterparty exposure is to do a coupon-only FX swap (without the final
exchange of “principal”)
• Original FX spot-forward swap that we looked at appeared to involve an
exchange of a zero-coupon bond in one currency for another zero-coupon
bond in another currency.
• A coupon-only swap is like an exchange of a strip of coupons in one
currency for another strip of coupons in another currency.