My Schweser notes say that “The plain vanilla currency swap is pay floating rate on dollars, pay fixed rate on foreign.” What does this mean? Can you give me an example? I looked up the web and it seems to say that “The plain vanilla currency swap is pay fixed rate on dollars, pay fixed rate on foreign.” So for example, the exchange rate is US$1.25 per euro. Then you can set up a plain vanilla swap like this: swap US$50M with 40M euro with a US$ rate 3.5% and euro rate 8.25%. So suppose one year later, the exchange rate becomes US$1.4 per euro. Then the part who owns euro will make 40M euro * 8.25% * 1.4 - 50M * 3.5% / 1.4 = 2.05M What would the Schweser’s plain vanilla currency swap looks like in an example?
There’s just no such thing as plain vanilla currency swap. They are done all different ways.
Plain-vanilla interest rate swap is a contract between 2 (international) parties having a ‘Fixed leg’ at one end and a ‘Floating leg’ on the other over its tenor. Floating Rates are calculated using a refrential interest rate such as LIBOR. Principal amount does not change hands, so it’s called the notional principal. Payment is done NET of this notional amount. - Dinesh S
Sorry guys, all was I talking about in my previous post was ‘Interest Rate Swap’, which is not the same as ‘Currency Swap’. ‘Currency Swap’ involves exchange of principal amount (at the beginning of the contract), exchange of coupon payments periodically and again an exchange of principal amount (at the end of the contract). the Intution here to exchange/swap the international currency is that the respective firms need that foreign currency for their operations and need to hedge off the Fx Risk. Please correct me if I am wrong… - Dinesh S
dinesh.sundrani Wrote: ------------------------------------------------------- > the Intution here to exchange/swap the > international currency is that the respective > firms need that foreign currency for their > operations and need to hedge off the Fx Risk. > > Please correct me if I am wrong… > > - Dinesh S Dinesh, I’m not certain about the need to hedge FX risk. I think a primary motivation for the currency swap is that each company has lower borrowing costs in its own respective country. Each firm borrows at its lower rate, swaps principal balances, and charges the other firm the rate at which it could have borrowed from a bank directly (i.e. higher). So while each company is paying market rates for its FX balance, it’s earning the difference between its borrowing and lending rates from the other side of the swap, offsetting total borrowing costs. Correct me if I’m mistaken (which seems to be more common these days) Your mention of the need of FX for operations is an important point. It reminds me of an actual LI question from 2006 in which the candidate had to know one of the primary differences between currency swaps and other types of swaps. Specifically, that most swaps are based on a notional principal (i.e. no actual funds are exchanged at contract initiation), but in currency swaps, the two parties do actually exchange currencies at contract initiation and termination.
We’re away from the question here, but what the heck. A nice (maybe a little fanciful) way of thinking about a currency swap is that there American Burger wants to open a store in Tokyo and Tokyo Squid-on-a-Stick wants to open a store in NYC. AB can borrow money in the US and Squids can borrow in Japan. A currency swap is just about Squids and AB using their home field advantages to help out the other party. Of course, they need to exchange currency up front because the need to build their restaurants and on the backend each party needs to repay their loans. (In Japan they really do think these squidcicles are delicious). Edit: Overlapped with hiredguns who says about the same thing I did. Edit 2: Except he left off the part about squidcicles.
good… we all are on the same page (atleast on Currency Swaps, if not other LOS’s) - Dinesh S
So can someone give me an example of a currency swap that “pay floating rate on dollars, pay fixed rate on foreign” as suggested by Schweser? Thanks
American Burger borrows at floating rates, squidcicles borrows at fixed.
All this talk of squidcicles is getting me hungry. ymc, if you’re asking us to hit google for you, I’m happy to do the typing because I’m just that kind of guy: http://www.riskglossary.com/link/currency_swap.htm There are more: Results 1 - 50 of about 175 for “vanilla currency swap”. Have fun! Keep asking AF this kind of question!
Well, I did google but I find more than one definition of “plain vanilla currency swap”. So I got confused. Thanks Joey for telling me there is no such thing, so now I know the Schweser question is wrong.