10w FinEcon 2024fall v3

Summary

This video explores key financial instruments, focusing on FX forwards, currency swaps, credit default swaps (CDS), and equity swaps. It discusses how a Korean company can manage foreign exchange risk by investing in USD bonds and using FX forwards to lock in exchange rates. The video also explains how CDS protect against default risks and the mechanics of equity swaps for hedging or speculation on stock performance. The overall theme emphasizes the importance of managing interest rate and currency risks in the financial markets using various derivatives and swap products.

Takeaways

• 😀 FX forward contracts allow businesses to lock in exchange rates for future transactions, mitigating FX risk when investing in foreign assets like USD bonds.
• 😀 A Korean company borrows KRW 1300 and buys USD 1, investing in USD bonds, but faces FX risk due to fluctuating currency values at maturity.
• 😀 To hedge against FX risk, the company can enter into an FX forward contract with a counterparty, which fixes the exchange rate at the time of the contract.
• 😀 An FX swap involves two transactions: an initial exchange of USD for KRW and a final reverse transaction, allowing businesses to manage FX exposure effectively.
• 😀 Credit Default Swaps (CDS) are used to protect against the risk of default on debt. The protection buyer pays a premium and receives a payout if the reference entity defaults.
• 😀 In a CDS, if the reference entity (like KTB) defaults, the protection seller (W Bank) pays the notional value of the bond to the buyer, protecting them from the loss.
• 😀 Equity swaps allow businesses to exchange the returns from a stock or equity index for fixed or floating interest rate payments, enabling them to hedge or gain exposure to market movements.
• 😀 In an equity swap, if the value of a stock (e.g., Samsung) rises, the buyer (e.g., Numa) must pay the increase in value to the counterparty (W Bank), and vice versa if the value drops.
• 😀 An important aspect of swaps is the management of risk factors such as interest rates, FX risk, and equity risk, which are critical in global financial markets.
• 😀 Interest rate swaps, cross-currency swaps, and other financial products like FX swaps and CDS play vital roles in managing exposure and mitigating risk in financial markets.

Q & A

What is the purpose of using an FX forward in the context of USD investment by a Korean company?

The purpose of using an FX forward is to hedge the foreign exchange (FX) risk associated with the USD investment. By locking in the exchange rate for one year, the company ensures that it can convert the USD back to KRW at a fixed rate, protecting itself from any unfavorable currency fluctuations.

How does the FX forward contract help manage FX risk in the scenario of a Korean company investing in USD bonds?

The FX forward contract locks in a future exchange rate between USD and KRW, so that the company knows in advance how much KRW it will need to repay after one year when converting its USD back. This eliminates the uncertainty about the value of USD in KRW at maturity, preventing potential losses from exchange rate movements.

What is an FX swap, and how does it work in this context?

An FX swap is a financial agreement where two parties exchange currencies at a set exchange rate for an agreed period. In this context, the Korean company enters into an FX swap with a bank, where they initially exchange KRW for USD and later reverse the exchange. The swap helps manage FX risk by fixing the exchange rate at both the start and end of the contract.

What are the key components of a Credit Default Swap (CDS)?

A CDS involves a buyer who pays a periodic premium to a seller in exchange for protection against the default of a reference entity (e.g., KTB bonds). If the reference entity defaults, the seller compensates the buyer for the notional amount. If no default occurs, the buyer continues to pay the premium without receiving a payout.

How does the protection buyer in a CDS transaction benefit from the contract?

The protection buyer benefits by receiving compensation if the reference entity defaults. In this case, if KTB bonds default, the seller (W Bank) will pay the protection buyer (Numa) the notional value of the defaulted bonds, providing a hedge against credit risk.

What is the role of interest rates in managing risk in swaps like the FX swap and CDS?

Interest rates are crucial in swaps because they influence the cost and value of the financial instruments. In FX swaps, interest rate differentials between the two currencies can affect the swap’s terms, while in CDS, the premium paid is often tied to the credit risk, which can be influenced by prevailing interest rates and market conditions.

What happens if the reference entity defaults in a CDS transaction?

If the reference entity defaults, the seller of the CDS (e.g., W Bank) must pay the protection buyer (e.g., Numa) the notional amount of the defaulted asset, which compensates the buyer for the loss in value. The CDS contract is then terminated, and the buyer is no longer required to pay the premium.

What is the difference between a credit default swap (CDS) and an FX swap?

A CDS is used to hedge against the default risk of a reference entity, such as a bond issuer, while an FX swap is used to manage currency risk by exchanging one currency for another at a fixed rate for a set period. A CDS protects against credit risk, whereas an FX swap manages exchange rate risk.

In the context of equity swaps, what happens if the underlying stock price increases or decreases?

In an equity swap, if the price of the underlying stock (e.g., Samsung shares) increases, the party that agreed to pay the performance of the stock will owe the other party the difference in value. Conversely, if the stock price decreases, the other party will owe the first party the difference, based on the agreed terms.

How does an equity swap function in the context of a stock's performance?

An equity swap involves exchanging the returns of an underlying stock. For example, if the price of Samsung shares rises from 70,000 to 90,000, one party will pay the other the difference (20,000 per share). If the stock price falls, the opposite party pays the difference. This swap allows participants to gain exposure to the stock's performance without directly trading the shares.