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.