Currency Swaps Research Articles

Swap Rates and Credit Quality

The impact of credit quality on swap rates is determined under alternative netting assumptions. With counterparties of different default risk, swap valuation is non-linear in the underlying promised exchange of cash flows. The impact of credit risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps.

Swap Rates and Credit Quality

ABSTRACTThis article presents a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (that is, a liability). The impact of credit‐risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps.

Banks, Risk, and FAS105 Disclosures

This study examines whether Statement of Financial Accounting Standard No. 105 (FAS105) footnote disclosures of off-balance-sheet financial instruments and derivatives provide risk-relevant information in addition to that provided by the balance sheet alone. A theoretical model relates market and industry risk measures to FAS105 disclosures. Empirical tests of the model reveal that these disclosures do provide risk-relevant numbers although the results are not uniformly strong. The balance sheet financial instruments explain 42 percent of the variation in market risk and 45 percent of the variation in industry-level risk among 499 U.S. commercial bank holding companies. FAS105 disclosures of off-balance-sheet instruments and derivative positions explain an additional 5 to 7 percent of the variation. Stronger evidence is presented that shows that certain controversial classes of derivatives are not associated with increased levels of market and industry-level risk. This latter evidence stands in contrast to the current notion that derivative contracts, especially interest rate and currency swaps, increase overall bank riskiness. Results also corroborate the FASB categorization of classes of financial instruments along two important risk dimensions: credit risk and market risk.

Credit risk exposure with interest and currency swaps

The increased use of financial derivatives like interest rate and currency swap contracts has drawn much attention, as it exposes banks to non-performance by their counterparts. This credit risk exposure is of great concern to monetary authorities, e.g. the Bank for International Settlements. In this paper a method for the determination of credit risk exposure is developed, in which the exposure is a function of interest rates, exchange rates, and lives of the contracts. To quantify the credit risk exposure, simulations of the variables have been used.

Currency Swaps: An Instrument of International Finance

A currency swap involves exchange of principal and interest payments in two different currencies between two parties. Swaps are off balance sheet transactions and have grown at a phenomenal rate. This article by Sivaprakasam Sivakumar and Anita Mathew focuses on the development of the swap market, presents an overview of currency swaps, and analyses the participants. It also discusses the basic types of swaps, assesses the risks and regulatory means of minimizing the risks, focuses on the practical applications, and evaluates the relevance of swaps to India.

International Financial Instability and the Financial Derivatives Market

The financial derivatives market evolved rapidly in the 1980s in response to the deregulation of financial markets and financial innovation. Encompassing futures, options, currency swaps, and interest rate swaps, this market has grown to a value of more than $8 trillion in outstanding contracts. While these financial innovations have assisted business enterprises in hedging risk, they have also created conditions for heightened financial fragility on an international scale. The rapid growth of the derivatives market has been accompanied by a lag in instituting regulatory controls that would limit the destabilizing impact of these new financial innovations. Since many derivatives involve cross-border trading, the derivatives market has led to increased international financial fragility and the attendant need for greater supranational governance of derivatives. To explore these themes, I will use a monetary theory of production provided by institutionalist economic theory.

Czech derivatives market becomes more liquid

In the last a few years, the volume of derivatives trading steadily increased, the market being built, in particular, by major Czech banks (including subsidiaries of foreign banks) and branches of foreign banks. The most common derivatives are currency forwards and currency swaps up to 6 months. They are used by banks for trading (i.e. purchase or sale with other banks or clients) and hedging foreign exchange positions. More and more clients demand these instruments to hedge their own operations, mainly foreign trade and short-term loans. Equity options have so far been used to buy securities through major securities dealers who sell options to foreign investors. Some banks offer currency options to their clients. But clients have small expertise how to handle with options e.g. how to do effective option hedging.

Currency risk and international property investments

Incorporating exchange rate fluctuations into the analysis of an international investment substantially alters the expected risk and return characteristics of the investments. With fluctuating rates, the value of a successful investment property could be devastated when converted to the investor′s home currency. This risk should be recognized and incorporated into the investment decision but, as results show, the ultimate strategy may not be periodic adjustments which have been used by many researchers, nor trying to hedge fully as others have suggested, but rather to examine returns in home market currency and leave exchange rate exposure decisions to the currency portfolio managers. Explores the possibilities of mitigating currency risk through several hedging instruments – forward and futures contracts, options, back‐to‐back loans and currency swaps. Results from a survey of international investors are also summarized and comments provide substantial evidence that investors are unsophisticated in dealing with currency questions.

Currency swaps and long-term covered interest parity

The present study employs daily data, as opposed to weekly data used in previous studies, to examine whether long-term covered interest parity holds when a currency swap is used as a hedging instrument. We find that large deviations were not rare during the late 1980s but such deviations have diminished in recent years.

DECISION‐MAKING MODELS TO FACILITATE THE USE OF SWAPS IN GLOBAL CONTEXT

For many years interest‐rate and currency swaps have been used by multinational corporations' management as a hedge against unforeseen contingencies in the capital market. However, the current literature does not contain specific decision‐making criteria or models for use by company management to decide whether a swap should be preferred to alternative forms of obtaining debt in the capital market. This research presents models and criteria to be used by management in the decision‐making process to obtain a desirable swap transaction in a unified international capital market.

Foreign currency swaps accounting: GAAP versus practice

This study surveyed the Fortune 500 firms to learn how they accounted for foreign currency swaps in the balance sheet and income statement. Data supplied by 71 respondents indicate that there is much diversity in the accounting for and reporting of currency swaps and that existing GAAP on this matter is perceived as inadequate. In light of these findings, this study provides an analysis of existing reporting standards and highlights the major implementation issues and the conflicting doctrines associated with such standards.

A non-parametric analysis of covered interest parity in long-date capital markets

The financially innovative currency swap has elevated the international mobility of long-term assets. Of interest is whether the covered interest parity condition now holds in these markets, with the currency swap as the forward-exchange risk hedge. The empirical conclusions presented in the paper suggest that deviations from covered interest parity (in excess of transactions costs) are not rare. Yet, while profit opportunities are not always short-lived, an analysis of the deviations in excess of transactions costs reveals that they diminish over time, and eventually disappear. (JEL F32).

Currency Swaps, Financial Arbitrage, and Default Risk

This paper constructs a model for measuring the gains realized by both counterparties to a currency swap that takes place in an international market in which financial arbitrage opportunities exist. Conditions are derived for zero-sum and nonzero-sum outcomes for both default-free swaps and risky swaps in terms of state-contingent interest rate/exchange rate parities. In an imperfect international capital market, swaps with default risk can give rise to greater gains than a default-free swap. Possibility of default, state by state, becomes a screening device for favorable and unfavorable exchange rate outcomes for each counterparty. Thus, the possibility of default, per se, is not the sole determinant of the degree of credit risk in a swap agreement. Covariability of exchange rates and default states plays an offsetting role.

China's Foreign Currency Swap Market

China's Foreign Currency Swap Market

Long-term covered interest parity: evidence from currency swaps

This paper constructs long-term arbitrage conditions using a now well- developed mechanism for hedging long-term currency positions, the currency swap. Using the arbitrage conditions, bond yields denominated in different currencies are compared across the onshore markets of Canada, Japan, Germany, Switzerland, the United Kingdom, and the United States, and within the Euromarket. The evidence indicates that long-term financial capital is as mobile across these markets as is short-term capital. This appears to be the case both within the Euromarket and across political jurisdictions.

Currency swaps, hedging, and the exchange of collateral

A model of currency swaps is developed where swaps provide superior hedging capabilities. Under the swap two parties in effect ‘lease’ assets that they own to one another for use as collateral, creating supewrior loan-collateral matching. This superior matching is reflected in lower borrowing costs to both agents (creating a dominant borrowing and hedging method). The swap contract is self-enforcing due to a mutual double bonding arrangement, where each side has an interest in the continuation of the exchange relationship. (JEL G2, F3)

The effect of the new risk-based capital requirements on the market for swaps

The new risk-based capital requirements for banks cover swap agreements as well as the normal on-balancesheet items. The capital calculation is based on a fixed small percentage plus the current market value of the swap, if it is positive. Using option valuation methodology, anticipated capital requirements over the life of a swap are calculated. These requirements are compared to cushions that banks might want to hold against the risks of above average loss rates. For interest rate swaps, the cost of the capital requirements is small, amounting to about 1 bp/year on a swap; in a matched pair, this would amount to 2 bp in the bid-offer spread. On currency swaps, the cost of the capital requirements appears to be much more substantial, closer to 4 bp per year on a swap. In a matched pair, the excess of the capital requirements over desired cushion could amount to 7 bp in the bid offer spread.

Long-term covered interest parity and the international swap market

This paper examines the pricing of long-term forward exchange contracts. It is established empirically that the traditional covered interest arbitrage pricing relationship is often violated, and that the behaviour of long- and short-term forward exchange rates is substantively different. It is argued that activity in the international currency and interest rate swap markets provides a potential explanation for the observed “mispricing”. In particular, fixed-to-fixed currency swaps provide another form of arbitrage which can affect long-term forward exchange pricing.

Financial Innovations: Some Empirical Evidence from the United Kingdom

This paper reports the results of an empirical study undertaken during 1988 into firstly the opinions of corporate treasurers in UK multinational corporations on the process of financial innovation and the relationship between the corporates and their banks in the context of this process, and secondly the use of financial innovations in the MNCs' management of foreign exchange risk. It concludes that in general treasurers were sceptical about financial innovations, and that the relationship between the corporates and their banks appeared to be going through a difficult phase reflecting the breaking up of traditional links between banks and their corporate customers. The findings on the use of financial innovations varied; while currency futures were not used at all by the MNCs, the treasurers tried out the use of currency options and swaps. A general conclusion was that the corporates' exchange risk management practices were short term orientated and innovations were incorporated into the day‐to‐day management of positions rather than into longer term strategic decisions.

International Capital Mobility: Direct Evidence from Long-Term Currency Swaps

This paper provides direct measures of the international mobility of long-term financial capital using interest arbitrage conditions previously applied only to short-term assets. Long-term arbitrage conditions are constructed using a now well-developed mechanism for hedging long-term currency positions, the currency swap. Asset returns are compared in the Euromarkets and in the onshore markets of Canada, Japan, Germany, Switzerland, the United Kingdom, and the United States. The evidence, discussed below, indicates that long-term financial capital is as mobile across these markets as is short-term capital. This appears to be the case both within the Euromarkets and across political jurisdictions.