Currency Swap

CFA Level III Derivatives
#1

I’m not getting the logic of converting foreign cash receipts using swap. My confusion is say a firm has US dollar cash flow of 100 in one year. The swap rates in US is 1% and India is 10% respectively. The current exchange rate is INR 60 / . Converting the annual US $ cash flow to Indian Rupee based on the swap would mean:

1st step: Dividing US cash flow by US interest rate = 100 divided by 1% = 10,000 notional principal

2nd step: Using current exchange rate convert US$ notional principal into the corresponding INR notional principal = $10,000 * 60 = INR 600,000

3rd step: Using these notional principals for the swaps, the firm will give $100 over the maturity of the swap for INR600,000 * 10% = INR 60,000.

This result is absurd, because I cannot possibly expect INR 60,000 in return for 100. This is an implied exchange rate of INR 600 / . This result is absurd. I’m surely missing something vitally important. Please if someone can explain what is going wrong here. Many thanks

#2
  1. Then you’ll get the 10% interest on the INR 60,000

5 by the end of the term you’ll convert the proceeds at the prevailing exchange rates (which might be affected by IRP)

  1. Net everything to calculate your profit/loss

USD 100 to INR 60,000 is the opium business model. This is out of the scope of CFA Level3

#3

It’s actually not absurd. It makes sense when you consider that the USD risk-free rate is 1% and the INR risk-free rate is 10%. You’re not exchanging equivalent cash flows; you’re exchanging interest payments on equivalent notionals. If the interest rates are different, the currency amounts exchanged won’t agree with the exchange rate. If the interest rates are wildly different (as in your example), the currency amounts exchanged will differ wildly from the exchange rate.

#4

That is my confusion. On an interest rate parity, on a forward basis, the exchange rate would be = 60*1.1 divided by 1* 1.01 = 65.35. Hence how do you reconcile the difference ?

#5

On the interest rate parity basis the exchange rates will be 60 * 1.1 divided by 1 * 1.01 = 65.35. If you can please explain the step 4. I have not come across step 4. Hasn’t the dollar cash flow of $100 already swaped for INR 60,000. Why again 10% of INR 60,000

#6

Thanks for your response. Here are my comments: There is no step 4. Because the INR 60,000 is the real cash flow in return for $ 100 . If the example was for a more narrow bound interest rate than a 1% / 10% , step 4 will give you irrational results as well.

#7

Stated as a fact with certainty.

Great. go for it

“The eye sees only what the mind is prepared to comprehend” , Henry Bergson

#8

S2000, could you explain the part where you say “it makes sense when you consider that the USD risk-free rate is 1% and the INR risk-free rate is 10%”?