Lesson 18 of 25
Four types of currency swaps exist:
Pay one currency at a fixed rate, receive another currency fixed rate.
Pay one currency at a fixed rate, receive another currency at a floating rate.
Pay one currency at a floating rate, receive another currency at a fixed rate.
Pay one currency at a floating rate, receive another currency at a floating rate.
A currency swap will have some (not all) similarities to an interest rate swap:
Value is zero at initiation.
For currency swap types 1-3, a fixed rate must be priced that so the present values to each party are equal.
Regarding type 4, since both rates are floating, a fixed rate does not need to be found.
Currency Swap Differences to Interest Rate Swaps
For currency swaps, an interest rate must be priced for each currency.
Each side of the currency swap has its own notional principal in its own currency. Therefore, if one side of the swap has a notional set to 1, then the notional for the other party will be 1/exchange rate.
For currency swap type 1 (fixed-fixed), the rate on the domestic side is the fixed rate on a plain vanilla interest rate swap in the home country. The rate on the foreign side is the fixed rate on a plain vanilla interest rate swap in the foreign country.
For swap types 2 and 3, (fixed-floating, floating-fixed), the fixed rate sides are determined by the fixed rate on a local swap and the floating rate will be based on the local short term rates.
For swap type 4 (floating-floating), the floating rates are based on local market floating rates.
Given the incremental complexity of pricing currency swaps over pricing interest rate swaps, candidates are encouraged to obtain proficiency in successfully pricing plain vanilla interest rate swaps before pricing currency swaps.
Valuing Currency Swaps
The same approach to valuing interest rate swaps applies to valuing currency swaps, with the additional complexity of moving exchange rates. This will make calculating the present values to each swap party a little more complicated.