Chapter 11 - Currency Swaps

Question 1

Explain what a currency swap is.

Answer 1

A currency swap is an exchange of cash flows based on notional principals denominated in two different
currencies. A plain vanilla currency swap involves a floating rate of interest on one currency and a fixed rate of
interest on the other currency.
Unlike an interest rate swap, currency swaps almost always involve an exchange of the principal amounts at
the origination of the swap and at the end of the swap. Also, because payments are based in two different
currencies, there is no netting of the cash flows. Each counterparty makes a payment on each payment date to
the other counterparty.

Question 2

Explain how currency swaps are priced.

Answer 2

Currency swaps can be viewed as a position in two bonds in a manner similar to interest rate swaps. The major
exception is that the two bonds are denominated in different currencies. Accordingly, the prevailing term
structure of interest rates in the two respective interest rate markets affect the value and pricing of the currency
swap. The prevailing spot exchange rate between the two currencies also affects the pricing of the swap.

Question 3

Calculate currency swap cash flows given all the inputs.

Answer 3

This is calculated in exactly the same manner as with interest rate swaps. Both counterparties make the full
payment to the other counterparty. There is no netting of cash flows.

Question 4

Calculate a company’s post-swap cost of financing.

Answer 4

This is also calculated in a manner similar to the discussion on interest rate swaps.

Question 5

Explain why currency swaps are used.

Answer 5

Currency swaps are used primarily when it is more financially advantageous for two companies to reduce their
respective cost of financing via a swap versus borrowing directly in the desired currency market.