VOLUME 1, NUMBER 17/June 26-July 3, 1995
***************************************************************** *DERIVATIVES 'R US is a weekly non-profit publication on the * *Internet user group misc.invest.futures that provides a simple * *non-technical treatment of various topics in derivatives. DRU * *is written by Don M. Chance, Professor of Finance at the Center* *for the Study of Futures and Options Markets at Virginia Tech. * *He can be contacted at dmc @ vt.edu or by phone at 703-231-5061* *or fax at 703-231-4487. DRU is for educational purposes only * *and does not provide trading advice. * * * *Back issues of DRU are available by anonymous ftp from * *fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed* *using a Web browser at * *http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file * *contents.txt can be viewed to see a list of old filenames and * *topics available for reading or downloading. * *****************************************************************
Before we start, let me comment on the new header. I've discovered that many new readers simply jump in to DRU without realizing exactly what it is so I thought I'd restate each week just what DRU is (education), what it isn't (trading advice) and who I am as well as the usual information on how to obtain old issues. This was prompted by a comment written by someone named Elias Crim (where's your e-mail address, Elias?) in Futures Magazine's 1995 Guide to Computerized Trading. It seems that Crim was telling the reader about futures information on the Net and picked up a single issue of DRU, stating as follows:
"Derivatives 'R Us: Option Pricing Silly name but pretty straightforward discussion of Black-Scholes vs. other option pricing models."
Obviously he got a very limited picture of DRU. As old readers know, DRU discusses a variety of topics. And while Elias clearly has the humor of a secret service agent, I'll bet he won't forget the name.
Also, please note that I'll be on vacation next week, so this week's issue will cover two weeks. The July 10 issue will be posted on July 11.
CURRENCY SWAPS
This week's topic follows in the line of last week's topic. A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.
Let's say a firm in the U.S. needs German marks to fund a construction project in Germany. It can issue a fixed-rate bond in German marks or issue a fixed-rate bond in dollars and convert those dollars to marks. Let's assume it does the latter. There are several ways to convert the dollars into marks. One way is to construct a dollar/mark currency swap. At the onset of the transaction, the firm takes the dollars received from the issue of the dollar denominated bond and pays them up front to the swap dealer who pays our firm an amount of marks.
Then at each scheduled coupon payment date, the firm makes the normal dollar interest payment. At the same time, the firm pays an agreed-upon amount of German marks to the swap dealer and in turn receives dollars. The receipt of the dollars offsets the payment of the dollar coupon interest. When the bond matures, the firm pays its bondholders in dollars but receives an equivalent amount of dollars from the swap dealer to which it paid an agreed-upon amount of marks.
The net effect is that the firm converted a dollar-denominated loan into a mark-denominated loan. The firm can take a loss or gain on the swap transaction alone but its overall position (swap plus dollar bond) is that it is exposed as a borrower to the German mark. If the mark weakens, it gains on its overall position though we should not forget that it may have exposure elsewhere in its assets to the German mark.
Note that the interest rates that determine the swap payments are fixed. Some swaps mix currency and interest rate risk by varying the coupon interest rate. These are called cross-currency swaps. In this kind of swap one or both interest payments are floating. For example, suppose the firm wanted to borrow at a floating rate in German marks. Then it could structure the swap so that its mark payments were made at the floating rate of Deutschemark LIBOR. If it had been forced to borrow at dollar LIBOR, it could have structured the swap so that it received dollar LIBOR and then paid either a fixed rate or Deutschemark LIBOR. Virtually any structure or set of features is possible.
Many of the important characteristics of interest rate and currency swaps are the same. Pricing the swap at the onset involves finding the exchange rate that gives the swap a zero initial value. Pricing the swap later in its life means finding the present value of the payments in each currency, converting to a common currency and netting the difference, which makes the swap either an asset or a liability to a given party and the opposite to the other. Dealers price and trade these swaps in essentially the same manner as interest rate swaps. However, there is one major difference: the principal is generally exchanged at the onset and at the termination of the swap. The potential for payment problems at the end of the swap gives an additional element of credit risk to the transaction.