Hi All!
I understand in theory that the no-arbitrage condition means that both fixed legs in a currency swap should be priced at par in their respective currencies.
I am having a bit of trouble wrapping my head around why it doesn’t matter that the fixed legs can differ (Let’s say equilibrium rates are 10% and 5% of notional).
Thank you in advance!
Because you have exchanged the principal at a given FX that negates all other effect to begin with.
So 5% on AUD 100 = 10% on INR 100 at an FX INR AUD 2.
Since the rates are fixed for the life of the swap the counter parties are really betting on the change of FX. So in case the INR AUD a becomes 1.5, the counter party receiving the INR cash flow benefits because of more AUD per every INR. In other words the party receiving INR becomes a net receiver.
The idea, in a nutshell, is that the currency exchange rate will adjust to make the value of the payments equal.
It won’t, of course, because interest rate parity’s job is merely to prevent arbitrage, not to predict the future, but it makes for a good theory.
In this universe, it’s closer to INR/AUD 54.