Currency swaps hedge FX?

CFA Level III Derivatives
#1

Guys,

I’m wondering if currency swaps hedge the FX risk. I haven’t yet read anything about that in the book. Or is it just done for the reason they mention: access to cheaper funding in another currency.

Thanks

#2

Of course, it does. Banks use it broadly.

#3

Yes, figured. Here is an example:

A US company has issued a bond in EUR. He no longer wants that exposure so enters a swap to pay interest in USD and receive interest payments in EUR.

The reason why the US company has just hedged FX exposure is because it will no longer be making an interest payment in a foreign currency - rather, he will pay interest in USD.

Correct?

#4

The exchange rate is set at the inception of the swap. There will be FX risk when you receive payments in one currency if you have to convert them to the other currency, however. So it hedges the risk somewhat, but not completely.

#5

So, in my example, when the US company receives back its principal in EUR, in theory, by converting it back to USD, it would be then exposed to the FX at the time of the principal exchange (i.e. at the end of the swap). Right?

#6

Let’s assume on Bank’s example, is more straightforward

Bank BS EUR is domicile currency

Asset Liability

Pool of Loan in Eur on EURIBOR Borrowings in CHF in LIBOR

Thus, exposed to A/L risk (gap)

SWAP

Pay EUR Interest on EURIBOR on same NP in desired currency, EUR

Receive CHF Interest on LIBOR on same NP in desired currency

Thus, position is partially sterilized. As S2000 said, not in full because there some risks left.

#7

I think I now get s200magician’s point. The interest payments you will receive in this case will be in foreign currency. If you translate them, there will be FX risk.

So. in the end, how does it “somewhat” hedges FX risk?

#8

So. In the end, beside SWAP enter into forwards and rolling them over and over. For one International bank or MNC with Treasury division is not problem at all. The problem begin when such hedgers become speculators.

#9

I see, but then how does the swap hedges FX partially?

#10

I explained above on bank example.

If they have borrowings in CHF with required outflows in CHF

and in SWAP they receive inflows in CHF. Without exchange transaction, they simply repay interest in CHF.

In Bank example, this is sterile transaction. There is no currency risk since, there is no currency exchange just swap one cash flow stream for another.

I agree, in some other occasions, if exchange transaction happens for some reasons, there may be some currency risks but it can be solved by forwards or use of other instruments. Each corporation has Treasury dpt for such transactions.

#11

Oh yeah, I got it now. According to my example, you have interest to pay in EUR, but you receive payments from the swap in EUR, and pay back in USD. So net net, you’re exposed to USD which in that case is the domestic country - so no FX exposure there.

Then, there’d only be exposure at the termination, if the principal has to be converted.

Thanks guys.

#12

Principals are notional and usually are not converted at all.