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Background to Currency Swaps

Currency swaps involve the exchange of interest and principal payments in one currency for similar payments in another currency. Unlike a standard IRS, the payments for both legs might be based on a fixed interest rate, both might be floating, or one leg might be fixed and the other floating.

 

From a valuation point of view, most currency swaps can be handled using the appropriate set of IRS functions. We can decompose a swap into a position in two bonds, where one bond is denominated in the 'domestic' currency and the other bond is denominated in a 'foreign' currency. The fair value of the swap is then just the net value of the short and long positions, where the value of the foreign leg is converted into domestic currency terms at the spot exchange rate.

 

Consider a swap in which a counterparty has contracted to pay coupons based on a domestic reference rate and receive coupons based on a foreign reference rate. The counterparty's position can therefore be characterized as a short position in a domestic bond and a long position in the foreign currency bond. The value of the swap (in domestic currency terms) is then:

 

Equation Template

where,

NPVfor = value of the foreign bond, expressed in foreign currency terms

NPVdom = value of the domestic bond, expressed in domestic currency terms

X = spot exchange rate, expressed as the number of units of domestic currency per unit of foreign currency

 

The value of the swap where the domestic currency is received and the foreign currency is paid is expressed as:

 

Equation Template

 

 

We can see from these characterizations that currency swaps can be valued using the IRS functions. The only additional parameter that is needed in the valuation process is the spot exchange rate. An example of this procedure is set out in the Currency Swap template.

 

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