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