Plain Vanilla Cross Currency Swap
- - Contract between two parties to exchange periodic coupon payments in two different currencies over a period of time (range from 2 years to over 10 years).
- - Coupon payments are calculated based on Principal amounts in two different currencies (REAL Principal, NOT ‘Nominal’)
- - Principals are predetermined using an agreed exchange rate.
- - Initial and final exchanges of principal are standard, but optional.
- - Coupon payments can be fixed vs. fixed, fixed vs. floating, or floating vs. floating.
Swap Pricing: Discounted Cashflows
Common Swap Structures
- Basic Swap
- - Basis swap (i.e. floating/floating) is one of the basic building block in fixed/fixed and fixed/floating CCS.
- - A basis swap in this context is defined as the exchange of LIBORs in two different currencies with both initial and final exchange of principal.
- - Cost of a basis swap is quoted against USD LIBOR flat (e.g. USD LIBOR vs YEN LIBOR 17 bps) and is driven by demand and supply of international funds flow.
- Fixed/Fixed Cross Currency Swap
- - A Fixed/Fixed Cross Currency Swap can be decomposed into three basis components: two IRS and a basis swap.
- Fixed/Floating Cross Currency Swap
- -A Fixed/Floating Cross Currency Swap
- - can be decomposed into two basis components: an IRS and a basis swap.
Principal-Only Swap
- - ABC company has 3 year funding in JPY and is required to hedge exchange rate exposure created by this foreign currency debt.
- - Believe that USD/JPY exchange rate will be relatively stable.
- - Company can hedge using a cross currency swap which protects both the coupon payments and principal repayment from exchange rate risk.
- - With the belief that exchange rate will be stable, company decide that it does not want to hedge the exposure associated with its JPY coupon payments.
- - Compared to a full cross currency swap, a Principal-Only Swap (POS) costs less because a POS does not provide a hedge against exchange rate risks on coupon payments.
- - Consider a 3-year USD/JPY swap with only principal exchange.
- - At maturity, company receives JPY principal and pays USD principal at current spot rate (in fact can be any agreed exchange rate).
- - Same as a long-dated forward contract of the company buying JPY and selling USD at current spot rate.
- - Due to the interest rate differential between JPY and USD, forward USD/JPY exchange rate is lower than spot rate (i.e. JPY at a premium).
- - The contract to buy JPY/sell USD forward at current spot rate has a positive value to the Company.
- - As a compensation to Citibank(i.e. to make NPV = 0), the Company will need to pay a periodic coupon (either in USD or JPY) to Citibank.
Coupon-Only Swap
- - Consider a 3-year USD/JPY swap with only coupon exchanges.
- - Principal: USD 10 million.
- - There are no principal exchanges.
- - If the USD fixed rate is known, we can solve for the JPY fixed rate.
Long-Dated Foreign Exchange
- - A Long-Dated Foreign Exchange (LTFX) contract is a Zero Coupon Currency & Interest Rate Swap
- - Instead of exchanging coupons, at the time of dealing, the Principal amount on one set of cashflows is set so that the NPV = 0.
Aside: Using Interest Rate Parity - Pricing Forward Foreign Exchange
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- Alternative I
- - Invest USD 1mm for 1 year at 6.15%
- - In 1 year’s time, buy JPY in Spot market
- - In 1 year’s time, there will be
USD 1,000,000*(1+6.15%) = USD 1,061,500.
* Note: The interest rate used here is the USD zero coupon rate
- in 1 year’s time:
- - Alternative I: USD 1,061,500
- - Alternative II: JPY 105,262,500
- - Therefore, Implied Forward Rate
JPY105,262,500 / USD1,061,500 = 99.16.
- The higher interest rate currency (USD) is expected to depreciate in value
- In market jargon, it “trades at a discount” .
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- Alternative II
- - Convert USD 1mm into JPY 105mm in the spot market
- - Invest JPY 105mm for 1 year at 0.25%
- - In 1 year’s time, there will be
JPY 105,000,000*(1+0.25%) = JPY 105,262,500
* Note: The interest rate used here is the JPY zero coupon rate
- Rather than using zero coupon rates, each currencies’ discount factors may be used
- * Short Cut:
Forward Rate = Spot X dfUSD/dfJPY105 X 0.9420 / 0.9975
