I’m not getting the logic of converting foreign cash receipts using swap. My confusion is say a firm has US dollar cash flow of 100 in one year. The swap rates in US is 1% and India is 10% respectively. The current exchange rate is INR 60 / . Converting the annual US $ cash flow to Indian Rupee based on the swap would mean:

1st step: Dividing US cash flow by US interest rate = 100 divided by 1% = 10,000 notional principal

2nd step: Using current exchange rate convert US$ notional principal into the corresponding INR notional principal = $10,000 * 60 = INR 6,00,000

3rd step: Using these notional principals for the swaps, the firm will give $100 over the maturity of the swap for INR6,00,000 * 10% = INR 60,000.

This result is absurd, because I cannot possibly expect INR 60,000 in return for 100. This is an implied exchange rate of INR 600 / . This result is absurd. I’m surely missing something vitally important. Please if someone can explain what is going wrong here. Many thanks

same person, same post word for word on May 5th 2015, now Jan 8th 2016?

on the cash flows you receive on a periodic basis - you do not do an implicit currency conversion.

you are paying the 10% interest on your cost of funds if you had borrowed in INR… So to receive the funds you would have had to pay a bigger cost. Now with the USD - you pay only 1% as cost of funds. That differential you are talking about is the 1:10 ratio on the interest rates, and believe me - something you have not shown here, or is not even shown in the text - you would have paid through the nose to get on to the sweet currency swap by way of premiums.

Thanks for this. Will help me get it if you can please guide on the cash flow: I’m blocked at +$100, -$100, +INR 60,000. The text book talks about this strategy for fixing the exchange rate. Thanks again

stop thinking about the conversion on the cashflows itself.

the extra 10 x magnification on the 60000 instead of 6000 (which you would expect at 60 INR per USD) is the magnification due to the 10% vs. 1% (10 times rate).

The exchange rate was locked in when you did the conversion of the “original notional 100/0.01 = 10000$” to the 600,000 INR (notional on the INR side).

And all the time in the future - you are making sure you get the 1% of that -> fixed 100$ foreign cash flow…

And that becomes the 60000 INR you get each period, no matter what.

so you have fixed up your cashflows in your domestic currency INR.

The currency exchange rate is to fix the notional principal ONLY based on the rate at the swap inception, and the prevailing domestic / foreign interest rates…

1% foreign interest rate -> hence 10000 $ notional in FX

INR 60/USD -> means 600000 INR notional in domestic INR --> Locked for determining the domestic notional

10% interest rate domestic = 60000 INR

you do not apply the FX rate conversion now to the cashflows at all.