Evaluating currency swaps

Discussion in 'P1.T3. Financial Markets & Products (30%)' started by Hend Abuenein, Sep 6, 2011.

  1. Hend Abuenein

    Hend Abuenein Active Member

    Hello David,

    When evaluating currency swaps as a portfolio of forward contracts, I saw that both in Schweser notes and Hull's book they net the cash flow of every year (in one currency) then they discount the net to its PV for every year , when all other methodologies of evaluating derivatives and assets tell us to discount cash flows for every leg of contract (do the exchange math for a single currency), sum up PV's then net the sums to obtain the value of the swap.

    Why is this particular valuation being done this way?

    The two methodologies render entirely different answers.

    Thanks

    Hend
  2. Hi Hend,

    Hull actually, as with interest rate swaps, values a currency swap both ways. (I do think i know what you mean, it is so each for one little difference to create a difference between the two approaches, I never seem to get them to match the first time. But they do).

    If you look at http://www.bionicturtle.com/how-to/spreadsheet/3.c.1-swaps/
    (download excel, please)

    ... the second tab is the currency swap.
    The first approach indeed employs the approach to "discount cash flows for every leg of contract (do the exchange math for a single currency), sum up PV's then net the sums to obtain the value of the swap"

    The second approach (lower panel) nets the cash flows (after converting one) first; to your point, unlike a regular IRP, this is not how they would net in "real life" as its a currency swap. But this is just the approach that value the swap "as if" it were a series of forward contracts. And, as in the XLS, it really should give the same result. (But, it's so easy to make the smallest mistake and get a different result, there are several points where a difference can be introduced. For one thing, you have to keep the compound frequency straight throughout, is usually where i've made a mistake). Generally, if they differ, it's a model problem.

    Thanks, David
  3. ciao

    ciao New Member

    Hi David,

    Are you familiar with cross currency basis swap where at every quarter, the fx is reset every quarter? I understand the purpose is to mitigate credit exposure. They've also introduced a break clause at the end to avoid a principle exchange at maturity. Can you elaborate on the mechanics and why such a construction doesn't change the economics, compared to the original format for cross currency basis swap. Thanks in advance.

    Jimmy
  4. ShaktiRathore

    ShaktiRathore Well-Known Member

    Hi if i can help,
    The cross currency basis swap is just another kind of currency swap with floating/floating interest rate on both sides. E.g. A(US resident) exchange 13m $ with B(europe resident) of 10m euros and A pays Euribor-basis spread on 10 m euros and B pays A Libor on13m $. B wants to purchase home in US so borrow loan of 13 $ in US $ 30 yr mortgage so interest pays are in US$ for B who is the resident of europe and faces currency risk each time he would make pays. So Bank in Europe will make a swap that will receive 10 m euro from B and pay Euribor(bank pays for basis spread in case it need dollar funding) on it to B while receiving Libor from B and receive 13m $ from A and pay Libor on this to A while receiving Euribor-basis spread from A thus B has converted euro floating liability to $ floating liability by paying Libor on it and the A has converted $ liability to euro liability at a less swap rate of Euribor-basis spread. for more see this link----
    I found a useful link on the same:http://www.nakisa.org/bestiary/CrossCurrencyBasisSwap.html

    thanks
  5. ciao

    ciao New Member

    Thank you very much. That aspect I am familiar with, which is your conventional construction for cross currency basis swap. However, given the large credit exposure due to principle exchange, banks have redesigned such basis swap to mitigate that credit risk, by introducing quarterly fx resets. That mechanism is new to me and would really appreciate, if someone can clarify that aspect to me. Thanks a lot,

    Jimmy
  6. ShaktiRathore

    ShaktiRathore Well-Known Member

    I as per my understanding goes and after some referrel from the net,
    The Spot rate movements increases counterparty risk beacuse in a currency swap the NP are exchanges, if european Bank receives xm $ from A in US and pays libor on it and receives y m Euros from B in europe and finally Bank needs to pay back the xm $ to A and ym euro to B as agreed in the currency basis swap.Now suppose the forex rate has led to dollar appreciation so that now bank needs to pay more euros for same dollars so that credit risk for A increases as now bank has more euros in liabilities and has more credit than before. To remove this risk the swap contract needs to be resettled at prevailing new spot rate so that the risk of credit risk is not there i.e. avoid more increasing counterpart exposure. In this way forex resettlement tries to diminish the credit risk from further arising.
    refer to the link:http://www.wilmott.com/messageview.cfm?catid=38&threadid=77028
    thanks

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