Kenneth R. Szulczyk
The U.S. government bailed out the investment banks and insurance companies except
Lehman Brothers. After the public had learned Lehman Brothers was insolvent, and the
government would not help it, the financial markets plummeted in September 2008.
Furthermore, the credit markets froze as all financial institutions stop granting loans. Roughly
350 banks and investors would lose their CDS insurance because Lehman Brothers issued
approximately $400 billion in CDSs on debt that was valued $155 billion. Unfortunately,
Lehman Brothers issued more CDS contracts than the amount of debt by 2.5 times. Finally,
Lehman Brothers bankrupted and began liquidating its assets. Lehman Brothers was the greatest
casualty of the 2008 Financial Crisis and the largest bankruptcy in U.S. history. Barclays, the
second-largest bank in England, bought Lehman Brother’s U.S. core assets for $1.3 billion,
including Lehman Brother’s skyscraper in Manhattan. Excessive greed doomed a 158-year-old
company.
Evaluating Currency Swaps
A currency swap is a periodic exchange of foreign currencies between two parties, viewed
as a swap of two forward currency contracts. One party is a swap dealer, usually a banker while
the other is an investor. Each payment to the counter-party is called a “leg.” Swaps allow
companies to invest in foreign countries. Company borrows from its local bank at a low interest
rate, and then swaps its loan with another company in the other country, where it invests. Thus,
the company has access to the foreign currency at a low interest rate. Swap contracts specify the
following:
Frequency of the payments between two parties. Duration of the swap. A method to calculate the swap payments or legs. One leg is a fixed payment while the
other leg is a floating payment. Fixed payment has a fixed rate, called the coupon of the
swap.We define swaps in four ways, and they differ in how the payments of legs are indexed.
This book only discusses a currency swap, where both legs of the swap are denominated in
different currencies. At time period 0, the value of a swap to both parties should be 0 or close to
- No one would enter a swap with a large negative present value for them. We list the notation
as:
Present value of discounted cash flows from the foreign currency cash flows is PVforeign. Current spot exchange rate is S 0 , the time we calculate the swap’s value. Present value of discounted cash flows from the domestic currency cash flows is PVdomestic.