Question

Please explain distinctions the price and the value of a currency swap. How does a currency swap work? What would affect the price of a currency swap? What would affect the value of a currency swap? Please thoroughly explain in details.

Answer 1

Price & value of currency swap:

Price of a currency swap is usually expressed as London interbank offered rate (LIBOR), plus or minus a certain number of points based on interest rate curve at inception & the credit risk of the two parties. The price of currency swap refers to an interest rate, specifically the interest rate that is used to determine the fixed rate payment of the swap.

To value an existing swap, one needs to know the notional value of the swap, the swap rate, floating rate in affect for the current payment period & whether the swap to be valued from either the fixed rate payer or receiver perspective.

Working of a currency swap:

A currency swap is considered as an off balance sheet transaction in which two parties exchange principal & interest in two different currencies. The parties generally involved are financial institutions who act on their own or as an agent of a non financial corporation.

In currency swap, on the trade date, the parties exchange notional amounts in two currencies. For example, one party would receive $10 million in British pounds while the other would receive $14 million in us dollars. This implies a GBP/USD exchange rate of 1.4. At the end of the agreement they would swap once again with the same exchange rate closing the deal. During the agreement period, each party pays interest periodically in the same currency at the principal paid to the other party. The interest can be paid at number of ways either fixed or floating or each party using different methods etc. On the maturity date, the parties exchange the initial principal amounts, reversing the initial exchange at the same exchange rate.

The price & valuation of the currency swap can be influenced by various factors like exchange rate fluctuations, fluctuations in the market interest rates, the trading counter parties can be exposed to funding risks, credit risks etc.