I know that Interest Rate Parity has to come into play with Currency Swaps, but I’m failing to visualize how. Can someone explain? I know it’s not technically an LOS… but I think it will help me to grasp how the whole thing works better.
are you thinking of the credit risk associated with a currency forward? IRP definitely comes into play here: here’s an example: a US manager buys a currency fwd to deliver 1M pounds in 6 months. current 6-mo fwd rate is $1.8095/pound. three months into the contract, spot rate is $1.8038/pound. us int rate = 5.5%, UK rate is 5.0%. credit risk of currency forward = PV(inflows to manager) - PV(outflows to manager) =[($1.8095x1M)/(1+0.055)^0.25] - [(1.8038x1M)/(1+0.05)^0.25] the key is which interest rates are used to discount which cash flows. here's how it relates to IRP. IRP says that: F = s\*(1+domestic rate) / (1+foreign rate) (this is when currency is expressed as domestic per foreign, in our case from the above, /pounds) this can be re-arranged to F/(1+domestic) = S/(1+foreign) so the take-away is always discount the cash flow from the forward by the rate in the numerator of the spot ($, or domestic in this case)