23: Introduction to Financial Risk ManagementNote that unlike interest rate swaps, the notional principal in a currency swap is often exchanged
at the origination and termination dates of the contract. If the notional principal were not exchanged
at the termination date, the US company would still be faced with a dollar liability when the dollar-
denominated bonds mature, and the Swiss company would be faced with a Swiss franc liability.
Another variant of the currency swap is the fixed-for-floating currency swap. This is simply a
combination of a currency swap and an interest rate swap. In this transaction, the first party pays
a fixed rate of interest denominated in one currency to the second party in exchange for a floating
rate of interest denominated in another currency. For example, if the US company in the previous
example preferred to borrow in Swiss francs at a floating rate of interest, and the Swiss company
preferred to borrow in dollars at a fixed rate of interest, the two companies could engage in a fixed-
for-floating currency swap.
Suppose that the US company could borrow $7 million in 10-year bonds with a coupon rate of 8%.
The Swiss company borrows SF10 million in 10-year bonds with a coupon rate of LIBOR + 100 basis
points. This spread of 100 basis points above LIBOR is a reflection of the credit rating of the Swiss
company. As in the currency swap, the two parties will exchange the principal amounts at contract
origination. At the end of the first six-month period, if LIBOR is 6.5%, the cost of the loan will be 7.5%
(0.065 + 0.010). The US company will pay SF375,000 [SF10,000,000 × (0.065 + 0.01)/2] to the Swiss
company in exchange for US$280,000 (US$7,000,000 × 0.08/2). For both parties, the semiannual cash
inflows from the swap contract are used to make the interest payments on the bonds that were issued
in the cash market. Upon termination of the swap contract, the principal amounts are exchanged again
and the bonds are retired.
CONCEPT REVIEW QUESTIONS 23-4
7 Describe how an interest rate swap is just a portfolio of FRAs.8 Why would any corporation hedge with forwards, futures or swaps if it could keep its upside
potential by hedging with options?23-5 FINANCIAL ENGINEERING
The key to a successful hedging strategy is the ability to identify and offset the underlying risk exposure
that has the largest impact on the company’s value. For many companies, however, the underlying risk
exposure is unique because the risk exposure is based on an asset whose value is not easily hedged. As noted
earlier, financial engineering is the application of finance principles to design securities and strategies that
help companies manage their risk exposures. In particular, financial engineering has meant combining
the risk-management building blocks – forwards, futures, options and swaps – in complex patterns in
order to achieve specific risk profiles that benefit corporate issuers, or to offer investors unique payoff
structures that help them optimise their investment portfolios, or both. For example, some companies are
not able to use off-the-shelf hedging instruments because those instruments do not have payoff structures
that will offset the company’s underlying risk exposures. Similarly, an institutional investor may desire an
investment security that has specific payoff structures, but no such security is currently available.
fixed-for-floating
currency swap
A combination of a currency
swap and an interest rate
swap