Topic 11: Currency Swaps

Question 1

What is a currency swap?

Answer 1

A currency swap consists of two streams (legs) of fixed or floating interest payments denominated in 2 currencies.

A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency.

Question 2

Where are currency swaps conducted?

Answer 2

Over the counter

Question 3

How does a swap work?

Answer 3

The first party borrows a specific amount of foreign currency from the counterparty at the current exchange rate.

Question 4

What are the 3 basic Types of Currency Swaps?

Answer 4

1. Fixed vs Fixed
2. Fixed vs Floating
3. Floating vs Floating

Question 5

What are the 3 objectives of currency swaps?

Answer 5

1. To hedge against fluctuations in foreign exchange rates
2. To ensure cheaper dept in foreign currency.
3. To be used in times of financial crisis as defence.

Question 6

How many cash flows are involved in a swap?

Answer 6

Stage 1: Start of the SWAP
- At the initiation of the swap, the two parties actually exchange the currencies in which the principals are denominated.

Stage 2: During the SWAP
- The parties make periodic interest payments to each other during the life of the agreement.

Stage 3: At the end of the SWAP
- At the termination of the swap, the parties again exchange the currencies in which the principals are denominated.

Question 7

What are the advantages of currency swaps?

Answer 7

1. Comparative advantage
   - Some medium-sized enterprises may be more well recognized in their local base country than outside and hence may be able to exploit comparative advantage by issuing domestic currency bonds & then exchanging this for another currency thru the swap.
2. Bonds denominated in certain currency may be more popular with investors eg. USD, hence borrowers may exploit this by issuing such bonds that are in demand and then use the currency swap to swap for another currency.
3. tax and regulatory considerations

Question 8

What is credit arbitrage opportunity?

Answer 8

Refers to a situation where an investor can profit from discrepancies in the pricing of credit-related instruments (like bonds or credit derivatives) across different markets or instruments, without taking on significant risk.

Question 9

What is effective cost of financing?

Answer 9

in %, how much interest, each company is paying for the debt.

Question 10

What is cost savings?

Answer 10

The cost savings refer to the % you save by taking on the swap exchange as compared to directly borrowing in the foreign market using the interest rate that they offer to you.

Question 11

How many basic points is 1%

Answer 11

100 basic points