Hello, If one wanted to speculate on a country’s path of policy rates are cross-currency swaps the way to go? For example, Turkey has a pretty liquid cross-currency swap market and many points on the xccy curve are liquid. From my understanding, a xccy swap is simply the implied yield in an fx forward contract. Buying/Selling fx forward contracts would then be a more clean way of speculating on changes in policy rates, BUT fx forwards are most liquid in tenors <1yr. If I was to sell a 5yr xccy Turkish swap with $10mm in notional; therefore, betting on hikes in policy rates that are not priced into the curve or betting that inflation will remain sticky far longer than the market currently realizes, I would have to exchange 10mm notional for 12.5mm notional in Turkish Lira (usd/try 1.25) at the swap's inception. With this structure, I'm paying x% in Turkish Lira and receiving x% in USD in interest. My question is - at what exchange rate will the principal amounts be exchanged at the swap's maturity? I'm asking because selling this xccy swap in the above example exposes me to fx risk as I need to manage the 12.5mm in Turkish Lira that is on my balance sheet as a result of the exchange of principal at the swap's inception at the usd/try spot rate. Would I just simply need to for example, buy usd/try (buy sell try) 1m contracts in the fx forward market and keep on rolling the contracts every month until a profit target or stop-loss is reached on the xccy swap? Or would the principal amounts at the swap’s inception be exchanged at the 5yr usd/try forward rate? Thanks.
You swap $10M for 12.5M turkish lira now and you swap 12.5M turkish lira for 10M back in 10 yrs. The way to think of a currency swap is that you borrow money on your home turf and someone else borrows money on their home turf and you swap everything about that. Since you borrowed $10M, you need $10M back at maturity of the swap. Swaps are a fine way of speculating on currencies if you want to speculate long-term. You can’t just call up your broker and do a Turkish lira FX swap, though.
Joey - thanks, but I’m not trying to speculate on the currency here, I’m trying to speculate on the path of Turkey’s monetary policy via xccy swaps. Their IRS market is very illiquid and underdeveloped at the present time; therefore, investors/hfs utilize the xccy swap curve to place their interest rate bets in Turkey. I want to bet that Turkey’s central bank will hike more than is currently priced into the curve at the 5yr point of the cross-currency swap curve. For example, I want to pay the 5yr xccy swap on 10mm USD. The present yield is 16%. I will therefore have to pay 16% and receive say USD LIBOR. At the swap’s inception, I will give the counterparty $10mm and they will give me 12.5mm of Turkish Lira. You state above that the principal amounts at the swap’s maturity will get exchanged at the same exchange rate as at inception. How can you speculate on the currency when you have no currency risk here since you know your 12.5 turkish lira will get you $10mm at maturity? I’m even more confused as to how I’m going to come up with 12.5 turkish lira when I have to pay 16% in interest? Am I earning that interest on the Turkish lira cash balance of 12.5mm that I have in my portfolio? Can you be so kind and give me an example of the cashflows due to principal exchange and profit I will receive if say the xccy swap rate rises to 17% the next day from 16% and I want to close out the swap.
If the bank hikes more than is in the current curve, the lira will depreciate in the FX markets so you would go short lira in the swap. Dangerous way to play interest rates though.