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skphang
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Cross currency swap conundrum

May 11th, 2006, 10:39 am

I never thought I'd be asking this question, but here goes...Looking at papers and textbooks regarding the valuation of cross currency swaps, there are 2 standard methods:(1) PV(swap flows in home country) - spot exchange rate x PV(swap flows in foreign country), where PV is done with the treasury zero rates of the respective countries(2) PV(swap flows in home country - swap flows in foreign country x forward rates), where PV is done with the treasury zero rates of the home countryHowever, the concept of present value (if I understand correctly), is the use of a discount rate that represents the cost of borrowing. If I look at cross currency swaps as a means of borrowing foreign currency, then I should be charged something above the treasury zero rate in the foreign country to compensate the foreign counterparty for country risk. In other words, a spread should be added to foreign treasury zero rate when calculating PV(swap flows in foreign country) in (1). This would be especially true if my country's sovereign rating is many notches below the rating of the foreign counterparty.Is this correct? If so, how does one calculate this country risk spread?Thanks very much.
 
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Geist
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Cross currency swap conundrum

May 11th, 2006, 12:04 pm

QuoteOriginally posted by: skphangI never thought I'd be asking this question, but here goes...Looking at papers and textbooks regarding the valuation of cross currency swaps, there are 2 standard methods:(1) PV(swap flows in home country) - spot exchange rate x PV(swap flows in foreign country), where PV is done with the treasury zero rates of the respective countries(2) PV(swap flows in home country - swap flows in foreign country x forward rates), where PV is done with the treasury zero rates of the home countryHowever, the concept of present value (if I understand correctly), is the use of a discount rate that represents the cost of borrowing. If I look at cross currency swaps as a means of borrowing foreign currency, then I should be charged something above the treasury zero rate in the foreign country to compensate the foreign counterparty for country risk. In other words, a spread should be added to foreign treasury zero rate when calculating PV(swap flows in foreign country) in (1). This would be especially true if my country's sovereign rating is many notches below the rating of the foreign counterparty.Is this correct? If so, how does one calculate this country risk spread?Thanks very much.Yes, that's correct. The difference is in fact traded and is called the currency basis . It's quoted as a spread over 3m Libor (e.g. 3m Lib flat vs 3m JPY Libor -x bps). This basis is essentialy another way of expressing the FX fwd rates and represents the cost of funding in one ccy vs investing in another ccy.
 
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skphang
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Cross currency swap conundrum

May 12th, 2006, 2:34 am

Thanks! Just to see if I understand correctly, if the FX forward points are negative, i.e. there is an expectation of strong currency appreciation in the non-US country, then it is actually cheaper to borrow USD in the non-US country than in the US itself? In other words, the currency gains outweigh the country risk, so the non-US country ends up paying less?
Last edited by skphang on May 11th, 2006, 10:00 pm, edited 1 time in total.
 
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caroe
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Cross currency swap conundrum

May 15th, 2006, 7:44 am

The currency basis reflects counterparty risk rather than currency risk, namely the credit quality of the banks quoting LIBOR. Currency basis has historically been high for Dollar-Yen basis swaps (or Dollar-Norwegian Krone basis swaps for that matter), reflecting the superior credit quality of banks quoting US Libor versus that of (Japanese) banks quoting JPY Libor
 
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skphang
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Cross currency swap conundrum

May 16th, 2006, 2:29 pm

Ok... I think I understand the currency basis. However, the basis affects the rates applied to the notionals. My question is about the discount curve used to find the present value of cash flows. Let's say that I am an 'A-' rated bank in an emerging market country that swaps the local currency for USD with an 'AA' bank whose parent is incorporated in the United States. What discount curve does the 'AA' bank use to discount the cash coming from the 'A-' bank? Does the 'AA' bank use only a typical 'A-' credit curve, or does it add a country risk spread to the curve as well?