Show how a currency swap converts an asset or a liability into another and compute the cash flows that follow.
The idea
A currency swap exchanges principal and interest in two currencies. The principal amounts are exchanged at the start at the spot rate. Interest is paid on each principal in its own currency during the life. The principals are exchanged back at maturity at the same initial rate. The swap converts a liability or asset in one currency into another. A firm with a USD bond that swaps to receive USD interest and pay EUR interest has effectively a EUR liability. The USD received services the bond, and the firm pays EUR interest and repays EUR principal. Net out each currency separately and keep any unmatched spread in its original currency. The classic mistakes are converting the final principal at the then spot rate instead of the agreed one, forgetting that principal is exchanged, and mixing up which currency each party pays.
A practice question
What distinguishes a fixed-for-fixed currency swap from a plain vanilla interest rate swap?
- Only the net interest is paid, and the principal amounts are never exchanged.Why not: Describes an interest rate swap; currency swaps do exchange principal.
- Principal in each currency is exchanged at the start and re-exchanged at maturity at the agreed rate. - correct
- Principal is exchanged only at maturity, at the spot rate prevailing then.Why not: Principal is also exchanged at the start, and the maturity exchange uses the original rate.
- Both parties pay interest in the same currency on different notionals.Why not: The legs are in different currencies, which is the point of the swap.
A currency swap exchanges principal in two currencies at inception and swaps them back at maturity at the initial exchange rate, with interest paid in each currency in between.
A harder one
A US firm has a USD 100 million bond paying 6.0% annually. It enters a swap in which it receives 5.8% on USD 100 million and pays 4.0% on EUR 90 million. Ignoring principal, what are the firm's net annual interest cash flows after the swap?
- Pays EUR 3.6 million and USD 0.2 million - correct
- Pays EUR 3.6 million and receives USD 0.2 millionWhy not: Reverses the direction of the USD residual; the bond coupon exceeds the swap receipt.
- Pays EUR 3.6 million and USD 6.0 millionWhy not: Does not net the USD received on the swap against the USD coupon.
- Pays EUR 3.6 million onlyWhy not: Ignores the 0.2% shortfall between the 6.0% bond coupon and the 5.8% received on the swap.
The swap pays EUR 90 x 4.0% = EUR 3.6 million, and the USD 5.8 million received covers part of the USD 6.0 million coupon, leaving USD 0.2 million to pay. The firm has a mainly EUR liability.
The hardest tier
A firm borrowed USD 92 million at the reference rate plus 0.9%. It enters a 4-year swap in which it receives the reference rate on USD 92 million and pays 3.1% fixed on EUR 80 million, with principals exchanged back at maturity at the original rate (1.15 USD per EUR). In the final year, what does the firm pay in total across the loan and the swap?
- EUR 82.48 million and USD 0.83 million - correct
- EUR 82.48 million onlyWhy not: Ignores the 0.9% spread on the USD loan, which the swap does not cover.
- EUR 82.48 million and USD 92.83 millionWhy not: Treats the USD loan repayment as unfunded, forgetting the USD 92 million received from the swap.
- EUR 2.48 million and USD 0.83 millionWhy not: Leaves out the EUR 80 million principal due at maturity on the swap.
The swap's reference-rate receipt offsets the loan's floating payment. The firm pays EUR 3.1% x 80 = 2.48 plus EUR 80 principal = 82.48, and the USD spread 0.9% x 92 = 0.83. The USD 92 million received at maturity repays the loan.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Swaps
- Work out the cash flows of a plain vanilla interest rate swap, explaining how it operates.
- Show how a plain vanilla interest rate swap converts an asset or liability into a different one, and work out the cash flows that result.
- Describe how financial intermediaries function in the market for swaps.
- State what function confirmation serves in a swap transaction.
- Set out the comparative advantage argument behind interest rate swaps and evaluate some objections to it.
- Describe how a plain vanilla interest rate swap's discount rates are computed.
- Value a plain vanilla interest rate swap as two bond positions held simultaneously.
- Treat a plain vanilla interest rate swap as a strip of FRAs and use that to value it.
- Value a currency swap as two bond positions held simultaneously.
- Use a series of forward exchange rates to value a currency swap.
- Recognise exotic swaps, credit default swaps, volatility swaps and commodity swaps as further types of swap and describe them.
- Outline how credit risk exposure arises for a party holding a swap position.