274 CHAPTER 7. MARKETS FOR CURRENCY SWAPS
given to her for the particular type of loan at hand.
Valuing an Outstanding Fixed-for-Fixed Currency Swap
The last issue that we discuss in the section on fixed-for-fixed currency swaps is
the valuation of such a swap after its inception. An assessment of the market value
of a swap is required for the purpose of true and fair reporting to shareholders
and overseeing authorities, or when the contract is terminated prematurely (by
negotiation, or by default, or by the credit trigger clause).
Just as a forward contract, the fixed-for-fixed currency swap acquires a non-zero
value as soon as the interest rates change, or as the spot rate changes. Since a swap
is like a portfolio of (a) a loan and (b) an investment in long-term deposits (or in
bonds), we can always value a swap as the difference between the market value of
the loan and the market value of the investment.
Example 7.5
Two years ago, a bank swapped a company loan (asset) ofusd100m forgbp50m
for seven years, at the swap rates of 4 percent on theusdleg and 5 percent on the
gbpleg. This reflected the long-term interest rates and the spot rate ofusd/gbp
2 prevailing when the contract was signed. Now the five-yearusdswap rate is 2.5
percent, the five-yeargbpswap rate is 4 percent, and the spot rate isusd/gbp1.7.
The procedure suggested by the International Swap Dealers Association is to value
the swap by applying the traditional bond valuation formula to each of the swap’s
legs. Thus, the company’susdoutflows are valued as
PVusd= 100m×[1+(0. 04 − 0 .025)×a(2.5%, 5 years)] =usd 106 , 968 , 742. 74 , (7.6)while itsgbpinflows are worth
PVgbp= 50m×[1 + (0. 05 − 0 .04)×a(4%, 5 years)] =gbp 52 , 225 , 911. 17. (7.7)At the spot rate ofusd/gbp1.7, thesegbpinflows are worthusd88,784,048.98.
The contract has therefore become a net liability, with valueusd88,784,048.98 –
106,968,742.74 = –usd18,184,693.76.
This finishes our discussion of the fixed-for-fixed currency swap. We now turn
to other types of swaps, the most important of which is the interest rate swap or
coupon swap.
7.3 Interest Rate Swaps
In an interest rate swap, there is still an exchange of the service payments on two
distinct loans. However, the two loans involved now differ not by currency, but