How Interest rate affects credit exposure of currency Swap

[Liming]

Dear David,


I don't understand the following sentences in blue colour (concerning the credit exposure for a currency swap as explained in page 515 of FRM handbook (5th edition)). Highly appreciate your kind help on this!

It says that: A similar issue arises with currency swaps when the two coupon rates differ. Low nominal interest rates imply a higher forward exchange rate. The party that receives payments in a low-coupon currency is expected to receive greater payments later during the exchange of principal. If the counterparty defaults, there could be a credit loss even if rates have not changed.

Thanks

Liming
17/11/09

 

[David Harper CFA FRM]

Hi Liming,

In our "naive" currency swap model
i.e., 2nd sheet in workbook: http://www.bionicturtle.com/premium/spreadsheet/3.a.11_hull_swaps/
we assume a constant currency exchange rate (e.g., yen/dollar = 110/USD and that is used to convert all of the received yen into dollars)...we are assuming a flat forward currency curve

Jorion is saying, per IRP, if the one currency is low, this implies a higher forward currency FX rate
i.e., yen/dollar foward = yen/dollar spot * exp((yen rate - dollar rate)*T)
if yen rate > dollar rate, foward > spot

so now, instead of a "level" FX conversion for all cash flows, they are "tilted" because the FX conversion is not level
as before, the initial swap is "fair deal" and priced so net value = 0
but, just like the regular IRS under an upward sloping yield curve, the exposure is not evenly distributed over time

David