Currency swaps

CFA Level II Derivatives
#1

When entering a currency swap I understand (from real life not from study material) that the exchange rate by which the two currencies are swapped back at the end of the contract are fixed.

Does this require an additional transaction (a forward?) or does this derive from the currency swap structure itself in some way I did not get?

#2

It’s part of the swap itself.

I give you GBP1,000,000 today, you give me USD1,250,000 today. We agree that one year from today I’ll give you USD1,250,000 and you’ll give me GBP1,000,000. Other stuff happens in the interim; we agree on that, too.

#3

Right, and all that I’m contractually agreeing on is that I’ll give you those USD 1,250,000 back, and its my responsibility to deal with that exchange rate risk (whether I buy them at spot at t = maturity, or enter into a forward to buy USD today at t = maturity). Is that right?

#4

OK but if the exch. rate changes in the meantime I carry the exchange rate risk. Unless I know how much the USD 1,250,000 will be worth in GBP. Which I can only know if I have a forward on it.

So I must also have a forward contract (sell USD forward for GBP with a maturity of one year from now). But if I understand well this is a totally separate contract. Banks just probably bundle it together.

#5

Yea Moosey, the notional amount will be specified at the contract’s outset, but there would be exchange rate risk if you either don’t already own the notional amount in the currency you need to swap at expiration or if you haven’t made a currency forward arrangement that matches the swaps maturity.

#6

OK thanks Black&Mamba!

#7

No problem, hope you’re enjoying the time off. I respect the fact you’re still studying in some way!

#8

It doesn’t require a forward.

Think what’s happening:

  • Today you give me, say, GBP1,000,000
  • For some period of time I pay you interest (fixed or floating) on GBP1,000,000
  • At the end of the swap, I return your GBP1,000,000

This is exactly what happens if you buy a GBP1,000,000 par bond. No need for a forward contract there; no need for a forward contract here.

#9

But if I give you 1m GBP in the beginning, for which you return to me 1.25m USD based on the prevailing exchange rate.

At the end of the swap the exchange rate changed, USD depreciated, so you return my 1m GBP but I must give you 1.3m USD.

In the examples during studying, when we valued open swap positions there was always a new exchange rate given which was factored in the value of the swap position.

in the examples I have seen during the study, where we had to value an ongoing swap, there was always a new (actual exchange rate given) which was factored in the valuation

#10

Wrong, wrong, wrong, wrong, wrong!

You’ll give me USD1.25m.

The trade at the end is in exactly the same amount as the trade at the beginning; the ending exchange rate doesn’t affect it.

Reread my first response.

#11

Well, that clarifies everything :smiley:

#12

Is it possible that where I am making a mistake is that:

the exchange rate risk I’m talking about exists only if we value a currency swap somewhere during the tenor (with the exch. rate valid on the day of the valuation?

and it does not exist at the end when we swap back?

#13

Yes I think that’s correct.

Quote from CFA L2 textbook

“Therefore, our swaps are showing gains as a result of the combination of interest rate changes in the two countries as well as the exchange rate change. To the counterparty, the swaps are worth these same numerical amounts, but the signs are negative.”

This is in the context of valuing a CCS before expiration.

To your original question, when you enter into a CCS, since there are 2 legs of currency exchange, there’s no need for additional forward contract to be done (FX rate hedged, but you incur the opportunity cost of potential FX gains)

#14

Thanks very much to all!