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 $100 over the maturity of the swap for INR6,00,000 * 10% = INR 60,000.
This result is absurd, because I cannot possibly expect INR 60,000 in return for 100. This is an implied exchange rate of INR 600 / . I’m surely missing something vitally important. Please if someone can explain what is going wrong here. Many thanks
you post the same question multiple times, do not look at the answer posted on your previous post…
answer lies in the 10% to 1% interest rate differential. so you cannot expect to achieve the forex rate that existed. you receive and pay interest in your own currency - so your cash flows are in your currency - without losing money in the exchange rate conversions. that is what the currency swap provides you.
the counterparty pays 100$ to the swap dealer
swap dealer pays you 60000 Rs. (10% of your 600000 Rs swap notional). So you are guaranteed the 60000 Rs each period.
Interest rate parity has nothing to do here. you are guaranteeing the 60$ conversion rate on your principal notional each time . if you go withoout the swap each time you might gain / lose on the exchange rate. especially since that would be based on the interest rate that is in effect at the time, and that you cannot predict.
Sorry for missing out your earlier comment and thanks for your time. I’m still not getting it because : I’m ending up with real cash flow of 60,000 rs by giving away $100. There lies my confusion or stupidity. Thanks again for your comments
The problem is this was straight from Level II. Actually in Level II this part had higher importance.
This should be among the least of your worries in LIII. This is a walk in the park.
Who said that luck don’t come into play for the CFA?