So far we have discussed swap contracts where the interest payments are both in the same currency. A cross-currency swap is similar to an interest rate swap, except that the currencies of the two legs are different. Like interest-rate swaps, the legs are usually fixed- and floating-rate, although again it is common to come across both fixed-rate or both floating-rate legs in a currency swap. On maturity of the swap, there is an exchange of principals, and usually (but not always) there is an exchange of principals at the start of the swap. Where currencies are exchanged at the start of the swap, at the prevailing spot exchange rate for the two currencies, the exact amounts are exchanged back on maturity.
During the time of the swap, the parties make interest payments in the currency that they have received when principals are exchanged. It may seem that exchanging the same amount at maturity gives rise to some sort of currency risk, in fact it is this feature that removes any element of currency risk from the swap transaction.
Currency swaps are widely used in association with bond issues by borrowers who seek to tap opportunities in different markets but have no requirement for that market’s currency. By means of a currency swap, a corporation can raise funds in virtually any market and swap the proceeds into the currency that it requires. Often the underwriting bank that is responsible for the bond issue will also arrange for the currency swap transaction.
In a currency swap, therefore, the exchange of principal means that the value of the principal amounts must be accounted for, and is dependent on the prevailing spot exchange rate between the two currencies.
The same principles we established earlier in the chapter for the pricing and valuation of interest rate swaps may also be applied to currency swaps. A generic currency swap with fixed-rate payment legs would be valued at the fair value swap rate for each currency, which would give a net present value of zero. A floating-floating currency swap may be valued in the same way, and for valuation purposes the floating-leg payments are replaced with an exchange of principals, as we observed for the floating leg of an interest rate swap. A fixed-floating currency swap is therefore valued at the fixed-rate swap rate for that currency for the fixed leg, and at Libor or the relevant reference rate for the floating leg.
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