7 • 16 INTEREST RATE AND FOREIGN EXCHANGE RISK MANAGEMENT PRODUCTS(a) Foreign Currency Swaps, Caps, and Floors.Corporations and investors often have
cash flows denominated in foreign currencies that arise over multiple time periods in
the future. For example, a Japanese corporation may have negotiated a contract for
the supply of crude oil at a fixed-dollar price over the next three years. Similarly, a
U.S. investor may have purchased a bond denominated in Swiss francs. In such cases,
there are cash inflows and outflows, the amounts of which are known in foreign cur-
rency terms, but are uncertain when converted into the domestic currency, the cur-
rency of account. In order to hedge the foreign currency exposure, the agent has to
enter into a multiperiod hedge instrument such as a foreign currency swap.
Consider the case of a U.S. corporation that has issued a five-year euro-bond de-
nominated in euros with a face value of 100 million and a coupon of 6%. If the cor-
poration wishes to eliminate foreign exchange risk and fix its funding cost in dollar
terms, it could enter into a five-year dollar/euro swap.
This transaction is basically a series of forward contracts on the dollar/euro ex-
change rate, where the company pays dollars and receives euros.
Contract Type Foreign Currency Swap
Term 5 years
Underlying foreign exchange rate Fixed $/Fixed
Reset period Annual
Swap rate (fixed) and position Pay 5% in $, receive 6% in
Face value 100 millionIn this example, the swap pays the difference between 5% in $ and 6% in , at the
prevailing exchange rate at the end of each year over the next five years, on an un-
derlying principal (face value) of 100 million. The payoff diagram in this case is
as follows:
+ 6% + 6% + 6% +(FV + 6%)0 –––––– 1 year–––––– 2 years –––––– 3 years –––———–– 5 years- 5% $ – 5% $ – 5% $ – (FV + 5%) $
At the /$ exchange rate fluctuates over the term of the contract; the swap will pay
positive amounts in some periods and negative amounts in others. Note that in con-
trast to the interest rate swap discussed previously, there is an exchange of principal
on the maturity date of the swap. This is because, unlike the interest rate swap, where
the face amounts on the fixed and floating sides are identical in value, in the case of
the foreign currency swap, the face amounts are in different currencies, and hence
would be worth different amounts depending on the exchange rate on the maturity
date. This currency swap, when combined with a similar-term euro borrowing, elim-
inates the foreign exchange exposure of the borrower in dollar terms. Hence, this
contract allows the euro borrower to switch to a dollar obligation.
There are several variations of the above transactions in practice. The main ones
relate to the interest rates used. In contrast to the above example, where fixed euros
are exchanged for fixed dollars, other variations would be fixed /floating $, floating
/fixed $, and floating /floating $. As in the case of interest rate derivatives, there