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8/8/2019 IFT_Sandipan

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Currency Swap:

A simple type of currency swap would be an agreement between two parties to exchange

fixed rate interest payments and the principal on a loan in one currency for fixed rate

interest payments and the principal on a loan in another currency. Note that for such a

swap, the uncertainty in the cash flow is due to uncertainty in the currency exchange rate.In a Dollar/Euro swap, for example, a US company may receive the Euro payments of the

swap while a German company might receive the dollar payments. Note that the value of

the swap to each party will vary as the USD/Euro exchange rate varies. As a result, the

companies are exposed to foreign exchange risk but if necessary this risk can be hedged by

trading in the forward foreign exchange market.

Currency swaps are over-the-counter derivatives, and are closely related to interest rate

swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the

principal.

There are three different ways in which currency swaps can exc hange loans:

1. The most simple currency swap structure is to exchange the principal only with thecounterparty, at a rate agreed now, at some specified point in the future. Such an

agreement performs a function equivalent to a forward contract or futures. T he cost

of finding a counterparty (either directly or through an intermediary), and drawing

up an agreement with them, makes swaps more expensive than alternative

derivatives (and thus rarely used) as a method to fix shorter term forward exchange

rates. However for the longer term future, commonly up to 10 years, where spreads

are wider for alternative derivatives, principal-only currency swaps are often used as

a cost-effective way to fix forward rates. This type of currency swap is also known as

an FX-swap.

2. Another currency swap structure is to combine the exchange of loan principal, asabove, with an interest rate swap. In such a swap, interest cash flows are not netted

before they are paid to the counterparty (as they would be in a vanilla interest rate

swap because they are denominated in different currencies. As each party effectively

borrows on the other's behalf, this type of swap is also known as a back-to-back

loan.

3. Last here, but certainly not least important, is to swap only interest payment cashflows on loans of the same size and term. Again, as this is a currency swap, the

exchanged cash flows are in different denominations and so are not netted. An

example of such a swap is the exchange of fixed-rate US Dollar interest payments for

floating-rate interest payments in Euro. This type of swap is also known as a cross-

currency interest rate swap, or cross-currency swap.


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Interest Rate Swap:Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate

specifications) for another. Because they trade OTC, they are really just contracts set up

between two or more parties, and thus can be customized in any number of ways.

Interest rate swaps often exchange a fixed payment for a floating payment that is linked toan interest rate (most often the LIBOR). A company will typically use interest rate swaps to

limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower

interest rate than it would have been able to get without the swap.

Types:

Being OTC instruments interest rate swaps can come in a huge number of varieties and can

be structured to meet the specific needs of the counterparties. By far the most common are

fixed-for-floating, fixed-for-fixed or floating-for-floating. The legs of the swap can be in the

same currency or in different currencies. (A single-currency fixed-for-fixed rate swap is

generally not possible; since the entire cash-flow stream can be predicted at the outset

there would be no reason to maintain a swap contract as the two parties could just settlefor the difference between the present values of the two fixed streams; the only exceptions

would be where the notional amount on one leg is uncertain or other esoteric uncertainty is

introduced.

Uses:

Interest rate swaps were originally created to allow multi-national companies to evade

exchange controls. Today, interest rate swaps are used to hedge against or speculate on

changes in interest rates.

Interest rate swaps are also used speculatively by hedge funds or other investors

who expect a change in interest rates or the relationships between them. Traditionally, fixed

income investors who expected rates to fall would purchase cash bonds, whose value

increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed

interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for

the same fixed rate.

Interest rate swaps are also very popular due to the arbitrage opportunities they provide.

Due to varying levels of creditworthiness in companies, there is often a positive quality

spread differential which allows both parties to benefit from an interest rate swap.

Risks:

Interest rate swaps expose users to interest rate risk and credit risk.

y Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed -for-floating swap, the party who pays the floating rate benefits when rates fall. (Note

that the party that pays floating has an interest rate exposure analogous to a long

bond position.)

y Credit risk on the swap comes into play if the swap is in the money or not. If one ofthe parties is in the money, then that party faces credit risk of possible default by

another party.


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COVERED AND UNCOVERED INTEREST RATE PARITY:

Interest rate parity is an economic concept, expressed as a basic algebraic identity that

relates interest rates and exchange rates. The identity is theoretical, and usually follows from

assumptions imposed in economic models. There is evidence to support as well as to refutethe concept.

Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in

one currency, exchanging that currency for another currency and investing in interest-bearinginstruments of the second currency, while simultaneously purchasing futures contracts to

convert the currency back at the end of the holding period, should be equal to the returnsfrom purchasing and holding similar interest-bearing instruments of the first currency. If the

returns are different, an arbitrage transaction could, in theory, produce a risk-free return.

Looked at differently, interest rate parity says that the spot price and the forward, or futures

price, of a currency incorporate any interest rate differentials between the two currencies

assuming there are no transaction costs or taxes.

Two versions of the identity are commonly presented in academic literature: covered interest

rate parity and uncovered interest rate parity.

Example Uncovered vs. Covered interest parity

Let's assume you wanted to pay for something in Yen in a month's time. There are several

ways to do this.(a) Buy Yen forward 30 days to lock in the exchange rate. Then you may invest in

dollars for 30 days until you must convert dollars to Yen in a month. This is called

coveringbecause you now have covered yourself and have no exchange rate risk.

(b) Convert spot to Yen today. Invest in a Japanese bond (in Yen) for 30 days (or

otherwise loan out Yen for 30 days) then pay your Yen obligation. Under this model,

you are sure of the interest you will earn, so you may convert fewer dollars to Yen

today, since the Yen will grow via interest. Notice how you have still covered your

exchange risk, because you have simply converted to Yen immediately.

(c) You could also invest the money in dollars and change it for Yen in a month.


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EXCHANGE RATE:

An exchange rate is the current market price for which one currency can be exchanged for

another.

NOMINAL EXCHANGE RATE:

It is defined as the actual foreign exchange quotation in contrast to the real exchange rate

which can be adjusted for changes in purchasing power.

Mathematical Formulation;

The nominal exchange rate is the price in domestic currency of one unit of a foreign

currency.

e X Pi=Pi*

Where: e denotes the nominal exchange rate of the domestic currency in terms of the

foreign currency.

Pi denotes the price of good i in domestic in domestic currency .

e X Pi is the price of the same good in domestic in foreign currency .

*Pi denotes the price of the same good in the foreign in foreign currency .

REAL EXCHANGE RATE:

Basically, the real exchange rate can be defined as the nominal exchange rate that

takes the inflation differentials among the countries into account. Its importance

stems from the fact that it can be used as an indicator of competitiveness in the foreigntrade of a country.

The Real Exchange Rate Definitions:

The various definitions of the real exchange rate can mainly be categorized under

two main groups. The first group of definitions is made in line with the purchasing power

parity. The second group of definitions, on the other hand, is based on the distinction

between the tradable and the non-tradable goods.

Purchasing Power Parity:

According to this definition, the real exchange rate can be defined in the long

run as the nominal exchange rate (e) that is adjusted by the ratio of the foreign pricelevel (Pf) to the domestic price level (P).

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