Topic 12: Swaps

Question 1

What kinds of swaps are there?

Answer 1

• Currency swaps.
• Interest-rate swaps. (not international finance)
• Cross currency interest rate swaps.

Question 2

What is a currency swap?

Answer 2

An inter-temporal agreement between two parties to:

1. Exchange principals of different currencies
2. Periodically exchange interest payments at given rates on and in the currencies received.
3. Reverse the principal swap.

Question 3

Show the payments of a currency swap where A recieves $6 million Yen, gives out $1 million yen to B, where the interest rate in Australia is 5%, and the interest rate in Japan is 2%

Answer 3

Question 4

Suppose:

• A sends B 40k in Euros every period.
• B sends a A 60k in Aud every period.

a) The spot rate in one period is S(^EUR/_AUD) = 0.7. Who benifits and who loses from the swap in this period?
b) How would we calculate the total benifit/loss for the swap to any party?

Answer 4

a)

• A pays 40k in euros. B pays 60k in Aus, which is worth (.7*60) = 42k Euros.
• Hence B pays A 2k Euros net. So a benifits by 2k Euros, and B loses by 2k Euros.

b)

• Sum all net transfers for the interest payments.
• Add the difference between the value of the final principal swap if it was made at the spot rate.

Question 5

What is a cross-currency interest rate swap?

Answer 5

An agreement between two parties to:

1. Exchange principal amounts in different currencies.
2. Periodically exchange interest payment streams on currencies received, one at a fixed, and another at a variable rate.
3. Reverse principal exchange.

Question 6

What is swap risk?

Answer 6

The risk that either party will default, either when certain periodic payments fail or the end principal transfer fails.

Question 7

Why would somebody want to engage in a cross-currency interest rate swap? Give an example.

Answer 7

• To eliminate a mismatch between income and payments.
• For example, a bank, which receives stable long term payments (at a fixed rate), but must pay it’s depositors at a variable rate might like to undergo such a cross-currency interest rate swap with a party whoes income is variable with the current interest rate, but whos cost is at a fixed rate.