Referring to reading 16 example 7 cross currency basis swap. can someone confirm whether the exchange rate is fixed for the duration of the swap, or the exchange of loan principal depends of the exchange rate at the time of exchange. In the CFAI material, it says the exchange rate is assumed to be fixed but can it differ in practice? Thanks in advance.
Oh yes ! There is indeed a potential threat of credit risk should the FX vary substantially than what was purported at the initiation of the swap contract.
So swap counterparties do two things :
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They exchange the physical principal at the FX rate( And seriously I don’t get how it may reduce the counterparty credit risk)
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The transaction are routed through banks of repute of the respective parties. The banks here stand custodian and become party to default if at all such a thing happens. However, this arrangement significantly reduces the credit risk arising out of Fx volatility.
ok, i take that at the time of returning the principle, the exchange rate at that time is used. Thanks HerbsDelite!
What’s not clear from the example is whether the payments are fixed or floating.
The answer, however, is rather stupid: the investor can convert the extra dollars to euro and have more net euro. That’s not what the investor wants, but it’s still a possible answer.
No. The FX are ignored at the time of returning the principal., The FX of the initiation is used and is presumed to remain constant throughout the life of the contract. The protection comes in the form of participating banks. These Banks may have multiple positions oitstnaidng with each other and with other FIs dealing with such Swap arrangements. As they may have others interest at stake ,they have really lesser chance of default…much lesser. Inter bank agreements are strong and act as shield against cross default .
So if at t=0 USD/GBR 1.25 for USD 10 Mn principal then the parties would exchange 10 Mn against £ 8 Mn. At t=T, the principal's would be re exchanged as it is i.e. £8 Mn against 10 Mn.
Just like an exchange the participating banks do the CVA ( credit value adjustment) to ensure that the parties do not run into the risk of defaulting should the situation turn unfavourable for them.
What if the swap counterparties still renege ?
Well they really have to be fools to do such a thing as their principal will be squared off against their CVA. Obviously the principal’s are much larger than the swap payments.
Do note, that with FX involved , there is no netting that happens here.