Currency Swap

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Currency Swap</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#currency swap">currency swap</a><p class="word_list"> <a href="#Vanilla currency swaps">vanilla currency swap</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">A <b><a name="currency swap">currency swap</a></b> is a form of <a href="../articles/swap.htm">swap</a>. It is most easily understood by comparison with an <a href="../articles/interest_rate_swap.htm">interest rate swap</a>. An interest rate swap is a contract to exchange cash flow streams that might be associated with some fixed income obligations—say swapping the cash flows of a fixed rate loan for those of a <a href="../articles/floater.htm">floating</a> rate loan. A currency swap is exactly the same thing except, with an interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are in different currencies. </p> <p class="body">That difference has a practical consequence. With an interest rate swap, cash flows occurring on concurrent dates are <a href="../articles/netting.htm">netted</a>. With a currency swap, the cash flows are in different currencies, so they can't net. Full <a href="../articles/par_value.htm">principal</a> and interest payments are exchanged without any form of netting.</p> <p class="body">Suppose the <a href="../articles/settlement.htm">spot</a> <a href="../articles/currency_codes.htm">JPY</a>/<a href="../articles/currency_codes.htm">USD</a> exchange rate is 109 JPY per USD. Two firms might enter into a currency swap to exchange the cash flows associated with </p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">a five-year USD 100MM loan at 6-month USD Libor, and</p> <! c o p y r i g h t ( c ) C o n t i n g e n c y A n a l y s i s , 2005 > <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">All cash flows associated with those loans are paid:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">initial receipt/payment of loaned principal,</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">payment/receipt of interest (in the same currency) on that loan,</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">ultimate return/recovery of the principal at the end of the loan.</p> <p class="body"><b><a name="Vanilla currency swaps">Vanilla currency swaps</a></b> are quoted both for fixed-floating and floating-floating (<a href="../articles/basis_swap.htm">basis swap</a>) structures. Fixed-floating swaps are quoted with the interest rate payable on the fixed side—just like a vanilla interest rate swap. The rate can either be expressed as an absolute rate or a <a href="../articles/spreads.htm"> spread</a> over some government bond rate. The floating rate is always "flat"—no spread is applied. Floating-floating structures are quoted with a spread applied to one of the floating indexes.</p> <p class="body">Currency swaps can be used to exploit inefficiencies in international debt markets. Suppose a <a href="../articles/corporation.htm">corporation</a> needs an <a href="../articles/currency_codes.htm">AUD</a> 100MM loan, but US-based lenders are willing to offer more favorable terms on a USD loan. The corporation could take the USD loan and then find a third party willing to swap it into an equivalent AUD loan. In this manner, the firm would obtain its AUD loan but at more favorable terms than it would have obtained with a direct AUD loan. That advantage must, of course, be balanced against the <a href="../articles/transaction_costs.htm">transaction costs</a>, <a href="../articles/presettlement_risk.htm">pre-settlement risk</a> and <a href="../articles/settlement_risk.htm">settlement risk</a> associated with the swap. This is illustrated in Exhibit 1.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="355" cellpadding="0" id="table7"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Swapping a USD Loan Into an AUD Loan</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex1_currency_swap.gif" width="350" height="250"></td> </tr> <tr> <td> <p class="exhibit_legend">By entering into a swap with a third party, a corporation can convert an USD loan into an AUD loan.</td> </tr> </table> </center> </div> <p class="body">Just as a <a href="../articles/interest_rate_swap.htm">vanilla interest rate swap</a> is equivalent to a strip of <a href="../articles/forward_rate_agreement.htm">FRA's</a>, a vanilla fixed-floating currency swap is equivalent to a strip of currency <a href="../articles/forward.htm">forwards</a>.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table8"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/basis_swap.htm">basis swap</a> A floating-for-floating interest rate or currency swap.<img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/currency_codes.htm">currency code</a> Any three letter code used to designate a particular currency.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">derivative instrument</strong></a><strong style="font-weight: 400"> An instrument that derives value from the value of some commodity, energy, or other financial instrument.</strong><p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><span class="verdana10"><strong style="font-weight: 400"><a href="../articles/garman_kohlhagen_1983.htm">Garman and Kohlhager (1983) option pricing formula</a></strong></span><strong style="font-weight: 400"> A formula for pricing European options on currencies.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_parity.htm"><strong style="font-weight: 400">interest rate parity</strong></a><strong style="font-weight: 400"> An arbitrage condition that must hold between the spot interest rates of different currencies.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_swap.htm">interest rate swap</a> A swap under which both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations. <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/swap.htm">swap</a> An OTC derivative under which two counterparties exchange two cash flow streams.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/swaption.htm">swaption</a> An option on a swap.</strong></td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; 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For a comprehensive treatment of swap markets, see Das (<a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm">2003</a>).</p> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap382"> <area target="_blank" href="http://www.riskbook.com/link/walmsley_j_(2000).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_walmsley_125.gif" usemap="#FPMap382" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/walmsley_j_(2000).htm"> The Foreign Exchange and Money Markets Guide</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Julian Walmsley</b></td> </tr> <tr> <td width="10%"> <map name="FPMap362"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"></map> <img border="0" src="../images/star_6.gif" usemap="#FPMap362" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap39"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap39" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2000</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap37"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/walmsley_j_(2000).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap37" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap591"> <area target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm" shape="rect" coords="0, 0, 84, 124"> </map> <img border="0" src="../images/book_das_satyajit_(2003)_125.gif" usemap="#FPMap591" width="85" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm"> Swaps/Financial Derivatives</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Satyajit Das</b></td> </tr> <tr> <td 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