10w FinEcon 2024fall v2

Summary

This transcript explains the mechanics of cross-currency swaps (CCS) and foreign exchange (FX) swaps, focusing on how foreign investors use these financial tools to convert and manage currency risks. It details the process of entering a CCS to exchange notional amounts in different currencies, pay floating or fixed coupons, and eventually receive or repay principal amounts. The example of a foreign investor borrowing USD, exchanging for KRW, and investing in Korean Treasury Bonds (KTB) illustrates the concept. Additionally, the transcript highlights how market interest rates affect the final cash flows in FX swaps and CCS transactions.

Takeaways

• 😀 Cross-currency swaps can be used to manage foreign exchange (FX) risk by exchanging notional amounts between two parties.
• 😀 In a typical cross-currency swap, two counterparties exchange a notional amount, and then agree to pay and receive interest (fixed and floating coupons) in different currencies.
• 😀 The final stage of a cross-currency swap involves repaying the notional amount in the original currency, completing the swap and offsetting cash flows.
• 😀 Cross-currency swaps can be used to convert USD-based bond investments into other currency-denominated bond investments, such as KRW or GBP.
• 😀 A foreign investor can borrow USD from the funding market, engage in a cross-currency swap, and purchase local bonds like KTB (Korean Treasury Bonds).
• 😀 Foreign investors use the cross-currency swap to mitigate currency risk and secure income from fixed-rate bonds like KTB, benefiting from the difference in coupon rates.
• 😀 The net income from a cross-currency swap can be calculated by subtracting the cost of the foreign currency coupon from the income earned from the bond's coupon.
• 😀 In the example of a USD borrowing and KTB purchase, if the foreign investor borrows USD 1 for one year and enters a cross-currency swap, they can earn net income after all cash flows are offset.
• 😀 Fixed-rate coupon cross-currency swaps involve exchanging fixed interest payments on different notional amounts, such as receiving a fixed coupon in USD and paying a fixed coupon in GBP.
• 😀 FX swaps involve shorter-term transactions where spot and forward exchange rates are agreed upon, and interest is not exchanged between counterparties. The notional amounts are repaid at the pre-agreed exchange rate.
• 😀 FX swap amounts may vary based on the exchange rate fluctuations and the interest rate of the respective currencies at maturity.

Q & A

What is a cross-currency swap (CCS) and how is it used in bond investment?

A cross-currency swap (CCS) is a financial contract in which two parties exchange principal and interest payments in different currencies. In bond investments, it is used to manage foreign exchange risk and convert cash flows from one currency to another, allowing investors to invest in bonds in foreign markets while managing currency exposure.

What role does counterparty A play in the cross-currency swap transaction?

Counterparty A is involved in the initial exchange of notional amounts with the swap bank, paying and receiving floating and fixed interest payments in different currencies. Counterparty A is also responsible for repaying the principal amount and the corresponding interest at the final stage of the swap agreement.

How does the cross-currency swap work for a foreign investor looking to buy Korean Treasury Bonds (KTB)?

The foreign investor borrows USD from the USD funding market, enters into a cross-currency swap to exchange USD for Korean Won (KRW), and then uses the KRW to buy Korean Treasury Bonds (KTB). They receive fixed coupons from the KTB investment and exchange interest payments through the swap. After one year, the investor repays the USD loan and the notional amounts are settled.

What are the potential income and costs for a foreign investor in this scenario?

The income for the foreign investor comes from the yield of the Korean Treasury Bond (e.g., 5% YTM). The costs include the interest on the USD loan and any currency swap costs, which can result in a net income depending on the difference between the bond yield and the swap costs. For example, if the USD borrowing cost is 3% and the bond yields 5%, the investor's net income would be 2%.

How do the fixed and floating coupon payments work in a cross-currency swap?

In a cross-currency swap, one party pays fixed interest in one currency and receives either fixed or floating interest in another currency. The fixed rate is typically set at the time of the swap, while the floating rate is tied to a reference interest rate, such as LIBOR or SOFR. The interest payments are exchanged periodically throughout the life of the swap agreement.

What is the difference between a cross-currency swap and an FX swap?

The key difference is that in a cross-currency swap, interest payments (fixed or floating) are exchanged between the parties during the life of the swap, while in an FX swap, only the notional amounts are exchanged at the start and maturity, without exchanging interest payments. FX swaps are typically used for short-term currency management and are less complex than cross-currency swaps.

How does the exchange rate affect the final outcome of an FX swap?

In an FX swap, the exchange rate at maturity can differ from the initial exchange rate depending on the interest rates of the two currencies involved. The final amount received in the foreign currency will depend on the agreed-upon forward exchange rate, which can vary based on market conditions and the relative interest rates of the two currencies.

What is the role of the notional amount in both cross-currency swaps and FX swaps?

The notional amount is the principal value on which interest payments are calculated. In a cross-currency swap, it is exchanged at the start and maturity, along with the interest payments. In an FX swap, the notional amounts are exchanged at the beginning and the end of the agreement, but no interest payments are made during the swap period.

What happens at the final stage of a cross-currency swap involving USD and KRW?

At the final stage, the foreign investor repays the USD loan, and the notional amounts (USD and KRW) are exchanged back. The investor also pays or receives the fixed or floating coupon payments based on the terms of the swap. Any profit or loss is determined by the net result of the bond investment and the currency fluctuations during the swap period.

What factors influence the amount of KRW received in a cross-currency swap?

The amount of KRW received in a cross-currency swap depends on the exchange rate between USD and KRW at the time of the swap and the interest rate differential between the two currencies. For example, if the USD interest rate is higher than the KRW interest rate, the amount of KRW received may be lower, reflecting the difference in the cost of borrowing between the two currencies.