Cross Currency Swaps FX Risk

[Nikolaos]

Dear David, colleagues,

I am already FRM certified, yet when working in the real world I find problems/situations where when looking back, I realise there things I didn't pay too much attention on. One of these is around cross currency swaps and somewhat generally FX products.

My question is: Do stand-alone cross currency swaps carry FX risk? If I were to just input 1 CCY Swap in an otherwise empty portfolio and run it through a risk system (which uses historical simulation), will I expect to show any FX risk on this position?

There are arguments both ways:

Will have FX risk:
- Cross currency swaps are instruments used for hedging (and speculation) FX. Therefore, simply going by logic, if something is hedging a risk factor, then it necessarily has positive or negative exposure to a risk factor.
- Spot FX is a component in the valuation of cross currency swaps. Therefore, spot FX is a risk factor, therefore we will show FX risk.
- The ending exchange of principal is fixed, therefore we have locked in a FX rate, therefore this would create P&L, therefore there is FX risk on the position.

Will not have FX risk:
- Like an FX swap, cross CCY swaps exchange principal at the beginning and at the end of the contract, which is like having a spot and a FX forward transaction packaged together, therefore the position will not show any FX risk.

The latter point is quite confusing in the context of decomposing a CCY swap into a series of forward contracts. Is this the case, or is it a series of forward contracts + a negating FX spot?

Many thanks all for your input.

Regards,
Nikolaos

 

[Nikolaos]

I am converging towards the thesis that cross currency swaps don't entail FX risk on their own and should be viewed as a domestic bond + a foreign bond + a forward FX. Or 2 domestic bonds with differing interest rates + a spot FX + a forward FX. In the end the only risk factor is the cross currency basis and any credit differential between the 2 rates involved (i.e. one may be secured vs other may be unsecured).

Welcome any thoughts. Seems like a simple topic but certainly one of the most confusing I have come across.

 

[David Harper CFA FRM]

Hi @nikogeorgiev I am knee-deep in FRM support so I can't dive into this with you. You might want to look at III.1.7.4 of https://forum.bionicturtle.com/reso...-trading-financial-instruments-volume-iii.92/

 

[bpdulog]

Let's say we both enter a swap with notional 100

You pay 10% rate

I pay 5% rate

Who has the higher exposure? I think it is the swap party paying the lower rate, because their EE is higher

 

[David Harper CFA FRM]

@bpdulog Without reading anything above, I disagree. The premise (assumption) is that we entered into a fair-deal swap with zero mark-to-market value for both of us. If you pay 5% to me, and I pay 10% to you, then you are immediately cash flow positive and I am negative. In order for the initial NPV zero to be true, I must be expecting to receive higher coupons in the future, so my exposure is greater. You, on the other hand, have "banked" or front-loaded your gains, so you are less worried about a current default than me.

 

[bpdulog]

@bpdulog Without reading anything above, I disagree. The premise (assumption) is that we entered into a fair-deal swap with zero mark-to-market value for both of us. If you pay 5% to me, and I pay 10% to you, then you are immediately cash flow positive and I am negative. In order for the initial NPV zero to be true, I must be expecting to receive higher coupons in the future, so my exposure is greater. You, on the other hand, have "banked" or front-loaded your gains, so you are less worried about a current default than me.

@David Harper CFA FRM I kind of understand what you're saying about the NPV value = 0, but how are you expecting to receive higher coupons? Look at the spreadsheet I laid out below:



If you are paying 10 to me for the life of the swap and I am paying 5, my EE is higher isn't it?

 

[David Harper CFA FRM]

@bpdulog Yes, under your scenario, clearly you have the higher credit exposure (e.g., EE) as, if we default immediately, you have more to lose here. But, I admit that I am introducing an unstated assumption: why would I enter into this expected deal? My NVP is a stream of negative $5? Can't we please just switch sides? (although, realistically, I have made a few investing mistakes, but I can't believe you are trying to talk me into this deal? #teasing )

So maybe I have too much of an exam mentality, but we typically assume that the counterparties begin the deal at zero (or nearly zero) value to each, which is maybe a way of assuming they are rational actors. I suppose your stream could represent the "tail end" of a currency swap wherein you were previously paying higher coupons, as a way to explain how we might be in this situation. I don't disagree with your conclusion from your chart. I am just saying that the FRM employs a concept like "whoever pays the higher coupon in a currency swap has greater credit exposure" (or not unrelatedly, whoever is paying the fixed rate when the interest rate term structure is positively sloped has greater exposure) because it is always making this implicit assumption of a fair deal at inception.

 

[David Harper CFA FRM]

@bpdulog I was thinking about this further given your "provocative" example, which in my opinion, cannot represent the full life of the swap (from inception to maturity) because it's not a fair deal at inception. Or put another way, it implies there must be further assumptions such as "the swap was earlier initiated and this is the remaining maturity." I do want to agree with you with respect to the merits of your example as it is literally shown. It reminds me of this swap example that I was recently discussing with @gargi.adhikari here at https://forum.bionicturtle.com/thre...ch7_currency_swap_valuation_revisedeg2.10178/

This is Hull's 7.12 and the situation is we have 10-year swap that has only four years remaining because Hull is effectively asking us to compute the credit exposure at the end of year six. (The literal question is "Suppose that company Y declares bankruptcy at the end of year 6, when the exchange rate is $0.80 per franc. What is the cost to the financial institution?"). So assume we are currently at the end of year six, immediately before the swap exchange. The financial institution is looking at:

• Year 0 [ i.e., end of year 6 in terms of the swap] = pay $320,000 (because pay $560,000 and receive USD 240,000) or - $320,000
• Year 1 = pay 308,400 or -308,400
• Year 2 = pay 296,100 or -296,100
• Year 3 = pay 283,300 or -283,300
• Year 4 [swap matures] = receive $2,400,100 or +2,400,100

The solution is the NPV [now at year 0 which is the end of year 6 in the swap] which is +$680,000; obviously that is positive to the FI because it expects to receive $2.4 million in four years. Equivalently, FI has credit exposure of max(0,$2.4 mm) = $2.4 million and the counterparty has credit exposure of max(0, - $2.4 mm) = zero or none. This is the literal sense in which I agree with you: if the cash flow scenario is complete, then whoever has positive NPV has the credit exposure. Related, what's interesting is the timing: if we go forward in time, say, just a few days, and assume that FI makes the $320,000 payment, then FI's credit exposure jumps up to $1,000,000 million because that becomes the positive NPV to FI. Hence the importance of clarifying whether that swap is yet settled.

My disagreement stems from the assumption that "we enter into a swap" and the suggestion that this is the beginning of the swap. In which case I would revert to the (FRM typical exam-type) approach of assuming the fair deal at inception. So, for example, if all that we know is that, in a currency swap, the FI is the net payer at the beginning, then we are justified in assuming that must be in exchange for the expectation of being a net receiver in later years, which in general current timing implies the FI has (greater) credit exposure. I hope that's an interesting "reconciliation" ... it helps me to think about it!

 

[Maxim Rastorguev]

David, concerning Hull 7.12. I thought if the company declared default, the bank was still supposed to make the 6th year payment in USD from his side, I can be wrong but it looks like "no netting of payments" is a real possibility in this case, how do you think?

 

[David Harper CFA FRM]

Hi @Maxim Rastorguev Hull's question 7.12 only refers to a single swap transaction where the counterparty in the single transaction defaults. But this is effectively close-out netting (albeit with the single transaction): if company Y does not default, then the FI owes a payment of 320,000 at the end of Year 6. Instead, company Y defaults and the FI does not make the payment, so Hull implicitly assumes close-out netting. It's negative value is included in the summation, which implies (as you suggest) the FI immediately withholds payment. This makes sense to me, although I suppose that I agree with you that Hull has omitted the implicit assumption of close-out netting; i.e., the termination of the contractual obligations by FI. Thanks,

 

[Maxim Rastorguev]

David, thank you. Can you please clarify one more question on swaps (I didn’t find in search) if possible. We say “swap is par rate” without reference to the fact that swap may not in fact be funded. But if I really want to borrow , I need real cash and funding. I feel there should be some differences. Let’s say swap 1y is 3%, but real money for 1y should be some 3% plus “delta”. Am I right?

 

[David Harper CFA FRM]

Hi @Maxim Rastorguev Yes, I think you are correct. Firstly, many of the historical practice questions (of any sort, not just FRM) often tend to omit the funding cost assumption. That is, a swap or par rate is calculated without regard to a funding assumption. (Although please note a swap, as a derivative, is assumed to be unfunded: unlike a bond where the investor-lender funds the principal, in the swap the notional is referenced such that "notional" is a good hint the vehicle is unfunded. This might not be iron-clad by I try to use "notional" when referring to unfunded derivatives, versus "principal" when referring to funded vehicles). However, it is correct to include a function cost adjustment (or assumption). Yesterday I was engaged on a not unrelated issue around the role of funding cost in the CDS-bond basis, see here https://forum.bionicturtle.com/threads/cds-bond-basis-factors-confusing-impact.10284/post-77743 ... also, not unrelated, Hull's recent editions of OFOD added the chapter of xVa which includes the funding valuation adjustment (FVA). In the swaps market, there a carry-cost (or cost of carry) component that can be calculated if the swap position is funded (more likely hedged). So I would say that, in my opinion, it is technically always correct to include an adjustment for funding costs (and many instruments already naturally do this) when warranted, but that at the same time, in practice I think sometimes it is omitted for the sake of convenience or simplicity. I hope that's helpful!