The application of currency swaps

The parties enter into currency swaps in order to hedge the currency risk from their assets or liabilities. As the swap runs for many years without any change in the exchange rate used, the currency hedging is long term. It is this long-term hedging of currency risk that makes currency swaps complementary to, and not in competition with, the forward exchange market.

An example of the mechanics of a fixed for fixed currency swap is given on pp. 344-6, and below an example is given of how a fixed for floating currency swap can be used to hedge the currency risk in new borrowings. Read more »

Posted: June 7th, 2008 under Futures Market.
Comments: 6

The exact nature of market risk will depend upon the nature of the swap: it will be interest rate risk, currency risk, equity market risk or commodity risk, according to the type of swap being considered. Generally intermediaries or counterparties will be able to hedge market risk, but credit risk cannot be hedged. However, it may be reduced substantially by holding a diversified portfolio of credit risks.

Credit risk

The fact that, at least for interest rate swaps, the principals are not exchanged means that the exposure to default is limited to the difference between the present value of the fixed and the floating cash flows. Consider a pay fixed/receive floating swap, first, from the viewpoint of the pay fixed side. We noted earlier that if interest rates have fallen since the swap was initiated, the swap will have a negative value to the pay fixed side — i.e. the present value of the future fixed payments to be made is greater than the present value of the floating payments to be received. Read more »

Posted: June 7th, 2008 under Futures Market.
Comments: 6