Currency Swaps Research Articles

The Implications of U.S. Strategic Rebalancing: A Perspective from Thailand

The Implications of U.S. Strategic Rebalancing:A Perspective from Thailand Kitti Prasirtsuk (bio) President Obama's participation in the East Asia Summit (EAS) for a second consecutive year confirms the United States' heightened attention to and engagement with Asia. Earlier, many Asian observers had doubted that a U.S. president could remain committed to attending the annual summit, particularly when the 2012 meeting was hosted by Cambodia, a relatively small country in the Association of Southeast Asian Nations (ASEAN). The fact that Obama kept his commitment to attend the EAS is evidence that the United States is stepping up its rebalancing efforts in Asia. This essay offers a perspective from Thailand—a traditional U.S. ally—on the motivations behind U.S. rebalancing, as well as on the policy's implications for Thailand and Southeast Asia as a whole. U.S. Motivations As seen from Thailand, there are four major motives behind the United States' rebalancing strategy. The first two concern China, while the other two motives relate to policy reorientation in the United States itself. First, China has gained considerable influence in East Asia, thanks in part to its strong relations with ASEAN. China became a dialogue partner in 1991, and its constant participation in the ASEAN Regional Forum (ARF) since 1994 and in other subsequent regional cooperation schemes has enabled Beijing to play a key role in the region. Alongside Japan, China has also been instrumental in setting the agenda for the ASEAN +3 forum. Among the most prominent achievements of the ASEAN +3 is the Chiang Mai Initiative Multilateralization (CMIM), the currency swap scheme aimed to help member countries suffering from a financial crisis. As the world's largest foreign-reserves holder, China is a formidable partner in the CMIM. Further, Beijing has pledged support for the Initiative for ASEAN Integration (IAI) and other programs to improve logistics connectivity, including the construction of roads, bridges, river ways, and high-speed trains, which will further link southern China with ASEAN. [End Page 31] On the economic front, China-ASEAN trade surged from $7.6 billion in 1990 to $186.5 billion in 2009, and China has been ASEAN's biggest trade partner ever since.1 This strong relationship is largely the result of the China-ASEAN free trade agreement, which was agreed to in 2002 and went into full effect in 2010. In the socio-cultural realm, China participates in a number of exchange programs with ASEAN countries, and Beijing's so-called panda diplomacy has likewise been effective. After leasing a couple of pandas to Thailand a decade ago, China has recently made similar deals with Indonesia, Malaysia, and Singapore. Moreover, Chinese tourists have become top visitors to many ASEAN nations, including Thailand.2 In short, China-ASEAN relations have been strengthened in several areas spanning the political, economic, and socio-cultural realms. Against such a backdrop, the United States could not remain on the sidelines. Second, China has become more assertive in its external posture. As Aaron Friedberg observed in the July issue of Asia Policy, this increasing assertiveness has been manifest on a variety of fronts, including Beijing's defense of North Korea over the sinking of a South Korean vessel, its confrontation with Japan over the arrest of a Chinese fishing boat captain near disputed islands in the East China Sea, and intensifying territorial claims in the South China Sea.3 At the same time, China continues to enhance its military capabilities, as demonstrated in the development of stealth fighters and an aircraft carrier. Given the strength of the Chinese economy, the country's defense budget will only increase in coming years. Third, the lack of attention paid to Southeast Asia during the George W. Bush administration, which was largely preoccupied with the war on terrorism in the Middle East, generated unfavorable perceptions of the United States. In particular, regional states noted the consecutive absences of Secretary of State Condoleezza Rice at the ARF meetings. During the Obama administration, the United States has sought to re-engage with Southeast Asia through sending high-level envoys, including Secretary of State Hillary Clinton, to visit the region and attend multilateral forums such as the EAS...

The Impact of Foreign Bank Deleveraging on Korea

Korea was hit hard by the 2008 global financial crisis, with the foreign bank deleveraging channel coming prominently into play. The global financial crisis demonstrated that a sharp deleveraging can be transmitted to emerging markets through the bank lending channel to a slowdown in credit growth. The analysis finds that a sharp decline in external funding led to relatively modest decline in domestic credit by Korean banks, due to concerted policy efforts by the government in 2008. Impulse responses from a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to Korea shows that it appears better prepared to handle such shocks relative to 2008. Indeed, Korea is much more resilient to such shocks due to the efforts by the authorities, which has led to the strengthening of external buffers, such as higher foreign exchange reserves and bilateral and multilateral currency swap arrangements.

The Impact of Foreign Bank Deleveraging on Korea

Korea was hit hard by the 2008 global financial crisis, with the foreign bank deleveraging channel coming prominently into play. The global financial crisis demonstrated that a sharp deleveraging can be transmitted to emerging markets through the bank lending channel to a slowdown in credit growth. The analysis finds that a sharp decline in external funding led to relatively modest decline in domestic credit by Korean banks, due to concerted policy efforts by the government in 2008. Impulse responses from a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to Korea shows that it appears better prepared to handle such shocks relative to 2008. Indeed, Korea is much more resilient to such shocks due to the efforts by the authorities, which has led to the strengthening of external buffers, such as higher foreign exchange reserves and bilateral and multilateral currency swap arrangements.

Local Currency Sovereign Risk

Do governments default on debt denominated in their own currency? We introduce a new measure of sovereign credit risk, the local currency credit spread, defined as the spread of local currency bonds over the synthetic local currency risk-free rate constructed using cross currency swaps. We find that local currency credit spreads are positive and sizable. Compared with credit spreads on foreign currency denominated debt, local currency credit spreads have lower means, lower cross-country correlations, and are less sensitive to global risk factors. Global risk aversion and liquidity factors can explain more time variation in these credit spread differentials than macroeconomic fundamentals.

Carry Trade and Liquidity Risk: Evidence from forward and Cross-Currency Swap Markets

This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.

The Price-Rate Duality: Theory of the Basis Spreads

After the Subprime Crisis of 2007, basis spreads quoted for swaps and cross currency swaps rose. Until that moment, these spreads could be considered negligible from a pricing point of view and, as a consequence of this, valuation systems did not include these spreads as relevant variables. However, for as long as the size of these spreads did not return to the previous level, their impact in pricing had to be considered. The most standard model consists in the substitution of the interest rate curve by several rate curves depending on: either the tenors in order to estimate their forwards (for pricing basis swaps), or the currency chosen as local currency in order to estimate discount factors (for pricing cross currency swaps). The model proposed in this paper postulates the existence of a Price-Rate duality in the swap market in order to get a deeper understanding of this phenomenon. Furthermore, this model establishes a new way of reducing the number of curves that the multi-curve model needs.

Efficient pricing and Greeks in the cross-currency LIBOR market model

We discuss the issues involved in an efficient computation of the price and sensitivities of Bermudan exotic interest rate derivatives in the cross-currency displaced diffusion LIBOR market model. Improvements recently developed for an efficient implementation of the displaced diffusion LIBOR market model are extended to the cross-currency setting, including the adjoint-improved pathwise method for computing sensitivities and techniques used to handle Bermudan optionality. To demonstrate the application of this work, we provide extensive numerical results on two commonly traded cross-currency exotic interest rate derivatives: cross-currency swaps (CCS) and power reverse dual currency (PRDC) swaps.

Graphics processing unit pricing of exotic cross‐currency interest rate derivatives with a foreign exchange volatility skew model

SUMMARYWe present a graphics processing unit (GPU) parallelization of the computation of the price of exotic cross‐currency interest rate derivatives via a partial differential equation (PDE) approach. In particular, we focus on the GPU‐based parallel pricing of long‐dated foreign exchange (FX) interest rate hybrids, namely power reverse dual currency (PRDC) swaps with Bermudan cancelable features. We consider a three‐factor pricing model with FX volatility skew, which results in a time‐dependent parabolic PDE in three spatial dimensions. Finite difference methods on uniform grids are used for the spatial discretization of the PDE, and the alternating direction implicit (ADI) technique is employed for the time discretization. We then exploit the parallel architectural features of GPUs together with the Compute Unified Device Architecture framework to design and implement an efficient parallel algorithm for pricing PRDC swaps. Over each period of the tenor structure, we divide the pricing of a Bermudan cancelable PRDC swap into two independent pricing subproblems, each of which can efficiently be solved on a GPU via a parallelization of the ADI timestepping technique. Numerical results indicate that GPUs can provide significant increase in performance over CPUs when pricing PRDC swaps. An analysis of the impact of the FX skew on such derivatives is provided. Copyright © 2012 John Wiley & Sons, Ltd.

Chinese Offshore RMB Currency and Bond Markets: The Role of Hong Kong

AbstractThis paper discusses the role of Hong Kong in China's grand scheme to build up the RMB as a global reserve currency. We highlight the economic importance of Hong Kong to China in terms of channeling foreign direct investment into China, some of which, in the future, will be denominated in the RMB. We discuss the development of China's RMB currency swap and deposit markets in Hong Kong. These offshore markets enable the RMB to trade freely, setting the stage for the RMB to become fully convertible and allowing market forces to play a role in pricing the value of the RMB, and help in the development of the RMB‐denominated bond (or dim sum bond) market in Hong Kong. Finally, we present evidence of the phenomenal growth of the dim sum bond market in Hong Kong, which can further enhance and strengthen the use of the RMB outside China.

Invited Editorial Comment

1. Peter Niculescu 1. is a partner at Capital Market Risk Advisors in New York, NY. TOPICS: [Legal and regulatory issues for structured finance][1], [futures and forward contracts][2], [interest-rate and currency swaps][3] The International Swaps and Derivatives Association (ISDA)

Quantifying the Variance Risk Premium in VIX Options

Barnea and Hogan use synthetically created variance swaps onVIX futures to quantify the variance risk premium inVIX options. The results of this methodology suggest that the average premium is -3.26%,meaning that the realized variance onVIX futures is, on average, less than the variance implied by the swap rate. This premium does not vary with time or the level of the swap rate as much as premiums in other asset classes. A negative risk premium implies that VIX option strategies that are net credit should be profitable. <b>TOPICS:</b>Exchanges/markets/clearinghouses, interest-rate and currency swaps, statistical methods

The US as ‘Sovereign International Last-Resort Lender’: The Fed's Currency Swap Programme during the Great Panic of 2007–09

Beginning in late-2007 and culminating in autumn 2008, the US Federal Reserve took extraordinary action to address global dollar scarcity through the provision of dollar swap lines with a total of 14 foreign central banks. At their peak, these emergency credit lines provided nearly $600 billion in financing to economies starved of dollars. This case represents an archetypal example of ‘sovereign international last-resort lending’. The article explores this case in order to engage the following two questions. First, what criteria qualify a state to play the role of international lender of last resort (ILOLR)? Second, under what conditions will a state with the capacity to act choose to do so? The article argues that the primary factor from which states derive the capacity to act as ILOLR is the international status of their national currency. Additionally, it contends that states with the capacity to act as ILOLR do so for defensive reasons. Examining the Fed's swap programme, three spillover effects are identified that threatened the US economy and motivated the US central bank to engage in defensive international last-resort lending during the crisis: financial system exposure, interest rate concerns, and a dramatic appreciation in the dollar's exchange rate.

Can Investing in Volatility Help Meet Your Portfolio Objectives?

Warren evaluates investing in volatility products under a range of investor objectives, including risk and return at the total portfolio level, benchmark-relative performance, and liability-aware investing. He shows that the potential role for volatility exposure depends on investor circumstances. Long positions in forward variance swaps or longer-dated VIX futures can be effective for hedging equity-related risk within balanced portfolios, but do so at the cost of exacerbating benchmark-relative risk and may be of limited benefit in certain liability-aware situations. Investors best placed to capture the volatility risk premium through shorting volatility include those with higher tolerance for total portfolio and benchmark-relative risk, longer investment horizons, or interest rate–sensitive liabilities. <b>TOPICS:</b>VAR and use of alternative risk measures of trading risk, interest-rate and currency swaps, equity portfolio management

Clean Valuation Framework for the USD Silo - An Implication for the Forthcoming Standard Credit Support Annex (SCSA)

In the forthcoming ISDA Standard Credit Support Annex (SCSA), the trades denominated in non-G5 currencies as well as those include multiple currencies are expected to be allocated to the USD silo, where the contracts are collateralized by USD cash, or a different currency with an appropriate interest rate overlay to achieve the same economic effects. In this paper, we have presented a simple generic valuation framework for the clean price under the USD silo with the the detailed procedures for the initial term structure construction. We have also shown that Cross Currency Swap (CCS) basis spread can be expressed as a difference between two swap rates.

Is It Possible to Reconcile the Caplet and Swaption Markets? Evidence from the U.S.-Dollar Market

One of the persistent and annoying puzzles in the area of interest rate derivatives is that models that can price interest rate caps consistently relative to their prices in the market fail to price swaptions properly, and vice versa, even though the payoffs to both types of derivative depend on the same spot and forward interest rates. Is reconciling the two markets just a matter of finding the right interest rate process? In this article, Rebonato and Pogudin take the very general class of models that falls within the LIBOR market model-stochastic alpha, beta, rho (LMM-SABR) family to explore whether a common valuation model can be obtained. Calibrating to caplet prices, they find overall reasonable fits but have difficulty matching swaption market prices; in particular, those with long underlying swapmaturities seem overpriced in the market. Exploring alternative assumptions on the term structure of forward rate volatilities and volatility of volatility brings them to a strategy that super-replicates a swaption payoff with an early-stopping cap contract. The model can price the two reasonably well, but in the market, the swaptions are regularly priced very close to the model-free noarbitrage bound. Moreover, the assumptions needed to get to that result entail highly unrealistic expectations about future cap prices. So, after careful exploration that illuminates the nature of the puzzle, the puzzle remains puzzling. <b>TOPICS:</b>Interest-rate and currency swaps, factor-based models

Evidence on Dynamic Loss Aversion from Currency Portfolios

Currency investors exhibit a tendency to cut risk by pairing both longs and shorts following losses and a weaker tendency to add risk following gains. By differentiating between position-level, portfolio-level, and aggregate cross portfolio losses in currency investments, the authors demonstrate that this dynamic loss aversion spans multiple frames of reference. Losses are not compartmentalized, but rather a loss in one currency may impact trading in another. The authors also show that while the impact of a loss on subsequent trading decisions does linger, the effect declines sharply after a losing position is closed. <b>TOPICS:</b>Portfolio construction, interest-rate and currency swaps, risk management

ABSTRAK and the Greeks: The Mathematics of Valuing Structured Securities in the Secondary Market

Since the publication of U.S. SEC Regulation AB in 2005, the securitization market has made substantial progress in accepting the need to standardize collateral data. However, to revive the market, the valuation framework for ABS, RMBS, and their derivatives also needs to be standardized. The authors argue that the most data-responsive valuation framework for structured securities is based not on Black–Scholes (where the risk analysis is circular, being reliant on ratings) but on classical fixed income mathematics—both the price of a bond and Taylor series approximations—with an adjustment for endogenous shifts in the credit quality of seasoning structured securities. <b>TOPICS:</b>Options, interest-rate and currency swaps

Worry-Free Inflation-Indexing for Sovereigns - How Governments Can Effectively Deliver Inflation-Indexed Returns to Their Citizens and Retirees

In this paper we explore how small countries such as Malaysia, Singapore, and Taiwan, can offer their aging populations the means to protect their retirement income against inflation without the governments directly issuing inflation-protected bonds. While inflation swaps are a well-known means by which to attain this, we show how an inflation index-replication strategy is also feasible. With this ability to provide inflation-adjusted returns, governments, pension funds, and other institutions can begin to offer a broad suite of inflation-indexed products, ranging from retirement annuities to inflation-linked insurance policies. This will improve the functioning of national pension systems, and hence the welfare of retirees. The added benefit of such structures is that they allow governments to broadly replicate their local Consumer Price Index (CPI) returns without disrupting their traditional financing structures. Given the potential of reinsuring national default risks across borders via currency and credit default swap facilities at the federal level, there is a unique role for the government in this process as the reinsurer of last resort.

A Krylov Subspace Method for Option Pricing

We consider the pricing of financial contracts that are based on two or three underlyings and are modelled using time dependent linear parabolic partial differential equations (PDEs). To provide accurate and efficient numerical approximations to the financial contract's value, we decompose the numerical solution into two parts. The first part involves the spatial discretization, using finite difference methods of the governing PDE. From this a large system of ordinary differential equations (ODEs) with a special affine structure is obtained. On the second part, we develop highly efficient numerical methods to approximate the exact solution of the system of ODEs with a high level of accuracy. We compare our approach, which is based of Krylov subspace methods, with the Crank-Nicolson and Alternating Direct Implicit (ADI) methods on Rainbow and Basket options, European call options using Heston stochastic volatility, and power reverse dual currency (PRDC) swaps with Bermudan and knockout features.

A New-Style Theory of Dual Currency Area &amp; International Public Currency: The Generalization of the Theory of OCA

Based on the “natural dual features” of world economy, we generalize the theory of OCA through redesigning and rejoining the fully independent affairs of national currencies and construct a new-style theory of dual currency area and international public currency. Firstly, we build an international public currency and “compound” exchange rate regime to provide a really stable monetary anchor for each national currency. Secondly, we set a “fully symmetrical” quota allocation and adjustment rule to international public currency with the neutral influence to generate net deficits or surpluses for each member country. Thirdly, we create a quota-based currency swap mechanism with “unlimited responsibility” for each national central bank that can provide a full issuance preparation for the supranational international public currency, namely full “hard” group insurance from all national currencies. Therefore, we originally provide a consolidated theoretical foundation to successfully create the supranational Asiancurrency, BRIICcurrency, or Globalcurrency, etc., which fully can “harmoniously coexist” with all different national currencies. And accordingly, we finally break a feasible brand-new path to thoroughly reform the current international monetary system and strengthen the future basket of international currencies, including IMF to allocate SDR or ECB to issue Euro, during this perplexed “after-crisis era”.