Money, Banking, and International FinanceWe calculate the swap value in Equation 11.ܽݓܵ ݁ݑ݈ܸܽ=ܸܲ∙ܵ−ܸܲௗ௦௧ (11)For example, Company XYZ enters into a 10-year swap agreement with a dealer. Nine
years have passed, and two semi-annual payments are remaining. Investors valued the swaps at
$200 million and 210 million euros with coupon interest of 4% for U.S. dollars and 5% for
euros. Therefore, coupon payments are $4 million and 5.25 million euros. Furthermore, the
implicit exchange rate is $4 million divided by 5.25 million euros, or $0.762 per euro. However,
the current spot exchange rate equals St = $1.25 per euro. Current discount rates are 5% APR for
the United States and 6% APR in Europe.
We compute the present value of cash flows for the European swap in Equation 12.
ܸܲ=
ହ.ଶହ €
ଵା.ଷ +
ଶଵ €ାହ.ଶହ €
(ଵା.ଷ)మ =^208.^0 ݈݈݊݅݅݉^ €^ (12)^
We compute the value of cash flows for the U.S. swap in Equation 13.ܸܲௗ௦௧=
ଵା.ଶହ +
ା
(ଵା.ଶହ)మ =$198.^1 ݈݈݊݅݅݉^ (13)^
We computed the swap's present value in Equation 14.ܽݓܵ ݁ݑ݈ܸܽ=ܸܲ∙ܵ−ܸܲௗ௦௧ (14)
ܽݓܵ ݁ݑ݈ܸܽ= 208. 0 ݈݈݊݅݅݉ €∙.ଶହ
ଵ € −$198.^1 ݈݈݊݅݅݉=$61.^9 ݈݈݊݅݅݉^
If Company XYZ liquidates the swap, the company must receive $61.9 million to sell the
swap. Company XYZ benefited because the company is exchanging dollars for appreciating
euros. Thus, the currency swap has a credit risk. Unfortunately, the other party, the dealer, has a
large negative present value and could default on the swap.
Why does the value of a currency swap change? Although terms of the swap are fixed,
fluctuating interest rates and changing exchange rates alter the swap’s value. If a company holds
a foreign currency while the domestic exchange rate appreciates, then value of swap decreases.
Remember the company entered into a contract for a foreign currency. If the domestic interest
rate increases, subsequently, the present value of the swap rises. Moreover, if the foreign interest
rate rises, then the present value of the swap must fall. Opposite is true for the issuer of the
swap.
Key Terms
spot transaction call option