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Currency and equity swap

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1 Currency and equity swap
Institute of Economic Studies Faculty of Social Sciences Charles University in Prague Currency and equity swap Ztlumené efekty: 2,3,4 Odstranit srážku kamionu: snímek 8, 1:33 – 1:45 Financial Instruments

2 Exchange rate conventions
Exchange rate is the price of one currency in terms of other currency (1 EUR = 1.25 USD, 1 GBP = 1.32 EUR) Base currency (BAC) is the measured currency ; BAC is represented by one unit in the exchange rate quotation Variable currency (VAC) is the measuring currency; VAC is represented by a number of units in the exchange rate quotation Possible exchange rate notations of 1 BAC = x VAC (1 EUR = 1.25 USD): x VAC/BAC (1.25 USD/EUR), x BAC/VAC (1.25 EUR/USD), x BACVAC (1.25 EURUSD) Quotation conventions Indirect quotation uses foreign currency as the base currency (a number of units of domestic currency per one unit of foreign currency) Direct quotation uses domestic currency as the base currency (a number of units of foreign currency per one unit of domestic currency) Conversion formula: x VAC/BAC ⇔ 1/x BAC/VAC 1.25 USD/EUR ⇔ 1/1.25 EUR/USD = 0.8 EUR/USD Currency and equity swap

3 Discounts and premiums
Classification of exchange rates Spot exchange rate is a rate agreed now for outright purchase or sale of one currency for another currency (with delivery of up to two working days) Forward exchange rate is a rate agreed now for purchase or sale of one currency for another currency in a fixed date in the future Covered interest rate parity Cash-and-carry transaction should generate neither a profit nor a loss VAC BAC ① Borrow one unit of BAC ② Convert BAC to VAC at a given spot rate 𝑆 ③ Deposit S units of VAC at VAC-interest rate to get S× 1+ 𝑖 𝑉𝐴𝐶 × days units of VAC 𝐹=𝑆× 1+ 𝑖 𝑉𝐴𝐶 × days 𝑖 𝐵𝐴𝐶 × days 365 ④ Convert the deposit balance back to BAC at a given forward rate 𝐹 to get S× 1+ 𝑖 𝑉𝐴𝐶 × days /𝐹 units of BAC ⑤ Repay the BAC loan 1+ 𝑖 𝐵𝐴𝐶 × days 365 To eliminated arbitrage opportunities, a higher interest rate must be offset by weaker forward rate The currency with the higher interest rate is at a discount to the currency with lower interest rate and the currency with the lower interest rate is at a premium to the currency with the higher interest rate Currency and equity swap

4 Related currency instruments
Outright forward Outright forward is the exchange of principal amounts denominated in two different currencies on a given future date EA Bank US Bank USD EUR time The exchange will take place at a current forward exchange rate Forward swap Forward swap is a temporary exchange of principal amounts denominated in two different currencies to be reversed on a given future date EA Bank US Bank USD EUR time The initial exchange is made at a spot rate and the re-exchange is made at a forward rate in accordance with the covered interest rate parity Forward swap can be seen as a combination of a spot deal and an outright forward Currency and equity swap

5 Currency swap Definition Types of currency swaps
Currency swap commits two counterparties to exchange: a) over an agreed period two streams of interest payments in different currencies b) usually at the end of the contract corresponding principal amounts at an exchange rate agreed at the start of the contract EA Bank US Bank USD interest USD EUR time EUR interest Principal amounts can be exchange at the start of the swap as well, usually in connection with a new borrowing Types of currency swaps Currency coupon swap involves an exchange of interest streams of which both are derived from a fixed rate of interest Cross-currency swap involves an exchange of interest streams of which at least one is derived from a floating rate of interest Currency swap is not a derivative instrument because there is an eventual movement of principal amounts on which interest payments are based Currency and equity swap

6 Hedged borrowing in foreign currency
Using cross-currency coupon swap Borrower FC interest Swap dealer DC interest DC revenues FC principal DC principal FC repayment FC borrowing Cross-currency coupon swap hedges fixed rate foreign loan against exchange rate risk and benefits from falling domestic interest rates In net terms the borrower pays DC interest and repays the DC debt from earnings generated by its domestic business Using currency coupon swap Borrower FC interest Swap dealer DC interest DC revenues FC principal DC principal FC repayment FC borrowing Currency coupon swap hedges fixed rate foreign loan against exchange rate risk and protects against rising domestic interest rates Currency and equity swap

7 Hedged investment in foreign currency
Using currency coupon swap Borrower FC interest Swap dealer DC interest DC outlays FC principal DC principal FC repayment FC investment Currency coupon swap hedges fixed rate foreign investment against exchange rate risk and protects against rising domestic interest rates In net terms the investor receives DC fixed interest and DC principal which are used for financing DC expenditures Using cross-currency coupon swap Borrower FC interest Swap dealer DC interest DC outlays FC principal DC principal FC repayment FC investment Currency coupon swap hedges fixed rate foreign investment against exchange rate risk and benefits from falling domestic interest rates Currency and equity swap

8 New-issues arbitrage Properties Example of new-issues arbitrage
An arbitrage trade with a currency swap involves bond issues in two different currencies EUR USD Company AA 6.5% 4.0% Company 𝐁𝐁 7.0% 5.2% Differential 50 EUR bp 120 USD bp Arbitrage potential 120 USD bp – 50 EUR bp AA has a comparive advantage in USD but needs EUR funds BB has a comparive advantage in EUR but needs USD funds = 75 USD bp = EUR bp Comparison of basis points in different currencies is achieved by using covered interest rate parity (i.e. 1 EUR bp = 0.9 USD bp) Example of new-issues arbitrage Co AA Co BB USD 4% EUR 6.0% EUR 7% AA net borrowing cost: USD 4% — USD 4% +EUR 6.0% = EUR 6.0% BB net borrowing cost: EUR 7% — EUR 6% + USD 4.0% = USD 4.9% EUR bp USD bp Company AA 50 45 Company BB 33.33 30 Currency and equity swap

9 Warehousing Risks of unhedged position Warehousing strategy
Later customer Swap dealer 5Y EUR + spread Earlier 5Y EUR 6M USD Libor USD EUR A fall in EUR long-term interest rates will result in a lower rate received than paid out during the whole term of the swap A rise of USD Libor will result in a higher rate paid out than received until the next refixing date A USD depreciation will result in a smaller USD principal amount received than paid out at maturity of the swap pair Warehousing strategy Buying 5-year EUR denominated government bonds A fall in EUR interest rate will increase the selling price of the bonds that will offset the income loss on EUR legs of the swap pair A USD depreciation will increase the USD equivalent of the EUR bonds that will offset the loss from the imbalance between USD principal amounts at maturity of the swap pair Currency and equity swap

10 Valuation of currency swaps
Valuation formulas Value of the currency swap is the difference between net present values of cash flows to be paid and received in the swap which are expressed in the same currency by using the market exchange rate Swap value (in units of CUR A) = NPV(CUR A)−NPV CUR B × exchange rate (CUR A/CUR B) Swap value (in units of CUR B) = NPV(CUR A)/ exchange rate (CUR A/CUR B)−NPV CUR B The swap value, based on current market interest and exchange rates, should be zero when the deal is originated The swap may acquire non-zero values after it is transacted as a result of market movements in the underlying interest and exchange rates Currency and equity swap 10

11 Equity swap Description
Equity swap is a contract which commits the counterparties to exchange over an agreed period two streams of payments 1. payments linked to a change in a agreed stock market index 2. payments linked to an agreed short-term interest rate Investor Swap dealer Libor + spread Stock index payment Both income streams are applied to an agreed notional principal amount (ES with a fixed notional principal) Market practice is to net payments so only one payment is actually made between counterparties Equity swap is a derivative instrument because it derives its payments from underlying cash instruments Equity swap is an over-the-counter instrument whose specifications are negotiated by the swap counterparties Currency and equity swap

12 Application of equity swap
Synthetic equity investment Equity swap can simulate investment in a stock market without the need to invest in this market (transformation of money market investment into a synthetic equity investment) Money market Investor Libor Swap dealer Index payment Libor + spread Repayment Cash investment Equity swap can circumvent regulatory restrictions on direct investment on the stock market Equity swap with a variable notional principal amount Equity-linked payments are reinvested in money market and equity-linked losses are funded by disinvestment in money market Principal is either increased by the amount equal to the index payment received or reduced by the amount equal to the index payment paid Trading strategy simulates stock market investment in which profits and losses are capitalised Currency and equity swap

13 Swaption Definition Application of swaptions
Swaption is an option to enter into a forward coupon swap Call swaption is the right to buy a forward swap (fixed interest is paid), put swaption is the right to sell a forward swap (fixed interest is received) Application of swaptions Company can put a ceiling on future borrowing rate by buying a call swaption Bank Company Loan Swap dealer Swaption Libor exercise rate 11% 6M Libor +1% If the swaption has a premium of 1% then the company can fix its effective borrowing cost at 13% 13% = 11% (fixed leg of the swap) + 1% (spread in the bank loan) + 1% (swaption premium) Any increase in borrowing rate up to 13% will be absorbed by the company Currency and equity swap

14 See you in the next lecture
© O.D. Lecturing Legacy See you in the next lecture Currency and ekvity swap


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