# currency swap

CFAI book 5 pg 499 Q 13:

" In order to raise 100 million Swiss francs, Millau needs to issue bonds totaling 100,000,000 SF/1.554 = €64,350,064. To convert the euros into Swiss francs, Millau could enter into a currency swap. In a currency swap, notional amounts are exchanged at initiation. In this case, Millau will pay €64,350,064 and receive 100 million in Swiss francs.

Subsequent payments do not net as they are denominated in different currencies. ( then, is this a different swap we are talking about?) Remembering to adjust the given swap rates for semi-annual payments, in six months Millau will pay (0.008/2) × 100,000,000 = 400,000 Swiss francs and receive 64,350,064 × (0.023/2) = 740,026 euros."

The currency swap calc are confusing for me. I did the amounts correctly but got the wrong direction. First, the Euro is exchanged for CHF and then here paying CHF and receive Euro?

Can anybody clear this up for me? Thanks

you need 100 M CHF. but your currency is EUR. You have better credit in EUR. So you would pay EUR, receive CHF.

So you enter into a Swap - pay EUR, receive CHF. (Initiation) pay 64 M Eur, Receive 100 M CHF.

Now in each period the swap is active - you pay CHF interest, receive EUR interest.

As with virtually all swap questions, if you draw a swap diagram, you cannot get this wrong. I haven’t read the question, but I can surmise what’s going on.

Millau wants to raise CHF1,000,000, but is issuing bonds in euro instead (maybe the interest rate’s lower, or something): EUR64,350,064. In your swap diagram you’d have a box for Millau and a box for the bondholders; they gave Millau EUR64,350,064, and he pays them interest in EUR.

Enter the swap counterparty (SCP, another box): Millau gives SCP EUR64,350,064 and SCP gives Millau CHF1,000,000 at initiation. On the payment dates (which correspond to the coupon dates on the EUR bonds), Millau gives SCP payments in CHF, SCP gives Millau payments in EUR, and Millau gives those EUR payments to the bondholders. At the end of the swap, Millau gives SCP CHF1,000,000, SCP gives Millau EUR64,350,064, and Millau gives the EUR64,350,064 to the bondholders.

If you net all of the payments, Millau gets CHF1,000,000 at initiation, pays coupons in CHF, and pays off CHF1,000,000 at the end, as if he had issued CHF bonds.

Voilà!

Thanks guys. The direction of initial exchange and subsequent payments are in different currencies-directions. I thought that since Milleu is domiciled in Euro, they can pay euro coupon the bonds they issued, so there was no interest payments. I do not see why they had to pay CHF to get Euro.

Milleu is domiciled in Europe, has better credit, so it is better of issuing a bond in Euros.

By paying interest of a fixed amount in CHF - they ensure they get the Euro amount with no exchange rate fluctuations by entering into the swap. They avoid the FX fluctuation.

They issued bond in Euros-I understand that they might have an advantage in issuing in Euros and they wanted CHF so they converted. They are paying interest in euros. Where is the question of fx fluctuations for interest payments? I just don’t see the logic for interest exchange.

If they really issued CHF bonds and paid everything in CHF, there would be no currency exchange rate issue.

Here, they issued EUR bonds. If they do nothing else, then they will have exchange rate issues for every coupon payment, and for the principle repayment.

However, when they enter into the currency swap, those exchange rate issues disappear: they’re paying the same amount of CHF coupons as they would have had they issued CHF bonds, they’re receiving the same amount of EUR coupons that they have to pay their EUR bondholders, and at the end they pay the same CHF principle as they would have had they issued CHF bonds and receive the same EUR principle that they have to pay their bondholders. No exchange rate risk whatsoever.

Thanks magician and cpk. I read the q again and I got it wrong the first time. I thought they were domiciled in EURO. That explains everything!!!

My pleasure.

Magician can you please explain your swap diagram methodology in a little more detail? I have struggled with exchange rates/currencies at all levels and particularly currency swaps at L2 and L3. Thanks.

all the examples in the book (CFAI) use the same box method.

draw boxes for the parties involved.

draw arrows for the cash flows and put amounts against them.