Welcome back YouTube to the Patrick
Boyle on Finance Channel. Another day, another video on derivatives
or quantitative finance. Today let’s learn about currency swaps. Okay so this
is my fourth video on swaps, if you want to watch the others I’ve put them all
together in a playlist which is linked to above. So let’s learn a bit about
currency swaps today. A currency swap is an over-the-counter foreign exchange
derivative between two institutions to exchange the principal and or interest
payments of a loan in one currency for equivalent amounts in net present value
terms in another currency so why do these things even exist at all well
currency swaps are used to obtain foreign currency loans at a better
interest rate than a company could probably get by borrowing directly in a
foreign market, or they can also be used as a method of hedging transaction risk
on foreign currency loans which you company is already taken out. An American
company may be able to borrow in the United States at a good interest rate
they might be well known by American lenders or they might have good access
to the capital markets but if they require a loan in euros for a new
factory we’ll say if they’re building a new factory in Germany they may not have
as good contacts in Europe and thus they might have to pay a higher interest rate
to attract euro denominated investors at the same time a European company might
wish to finance a project in the United States where it’s direct borrowing rate
is higher when compared to the rate that they could get in their local market
instead of going through all of the complexity of borrowing in foreign
currency or issuing the foreign currency bond the two companies could simply
borrow in their local currencies where they get better rates and then just swap
into the currency that they had wanted to borrow in to begin with they do this
you a derivative called a currency swap a
currency swap differs from an interest rate swap in that both principal and
interest of the loan are exchanged in an interest rate swap there’s no reason for
the counterparties to wire each other the identical notional amount it does
make sense in a currency swap though because the sum of money is denominated
in two different currencies and after all that’s what they had wanted was to
borrow in a different currency than their domestic currency the principal
amounts are exchanged at the beginning and again at the end of the life of the
swap the principal amounts are typically chosen to be equal given the exchange
rate at swap initiation so that the value at inception is zero the purpose
of a currency swap is to transform the borrowing currencies of the
counterparties okay so now that we know what a currency swap is and why people
might use them let’s look at an example. We’ll use the example from my book
Trading and Pricing Financial Derivatives that all these videos are
based upon. The table that you see on the screen right now shows an example of a
four-year agreement between us a company and Brit company where US a
company pays 63 percent in GBP of British pounds and receives fixed four
percent in u.s. dollars they each make one interest payment per year and the
principal amounts are 15.2 million dollars and 10 million pounds this is a
fixed for fixed currency swap okay so I imagine your next question is, but
Patrick how do we value these currency swaps? fixed for fixed currency swaps can
be broken down into a position in two bonds as with the interest rate swap or
into a series of forward contracts you can watch my video on how they are
valued at the link above if you are the local currency received leg of the swap
the swap value is equal to the bond value with domestic
cash flows – the spot exchange rate times the foreign price bond with
foreign cash flows if you own the foreign currency received leg of the
swap its value equals the spot exchange rate times the foreign price bond with
foreign cash flows – the bond value with domestic cash flows so that’s it on
currency swaps make sure to hit the like button if you found this video helpful
and hit the subscribe button if you wish to see more of my videos on derivatives
and quantitative finance have a great day and see you soon bye