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Topic Title: Cross currency swap conundrum Topic View: Linear

Created On Thu May 11, 06 12:39 PM

Thu May 11, 06 12:39 PM

I never thought I'd be asking this question, but here goes...

skphang
Member 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
Posts: 141 treasury zero rates of the respective countries
Joined: Jul 2002 (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 country

However, 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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Thu May 11, 06 02:04 PM

Geist Quote
Member
Originally posted by: skphang
Posts: 161
Joined: May 2003 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 country

However, 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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Fri May 12, 06 04:34 AM

Thanks!
skphang
Member Just to see if I understand correctly, if the FX forward points are negative, i.e. there is an expectation of strong currency
Posts: 141 appreciation in the non-US country, then it is actually cheaper to borrow USD in the non-US country than in the US
Joined: Jul 2002 itself? In other words, the currency gains outweigh the country risk, so the non-US country ends up paying less?

Edited: Fri May 12, 06 at 05:02 AM by skphang

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Mon May 15, 06 09:44 AM

http://www.wilmott.com/messageview.cfm?catid=8&threadid=38406 5/11/2011
Wilmott Forums - Cross currency swap conundrum Page 2 of 2

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

caroe
Member
Posts: 123
Joined: Jul 2002
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Tue May 16, 06 04:29 PM

Ok... I think I understand the currency basis. However, the basis affects the rates applied to the notionals. My question is
skphang
about the discount curve used to find the present value of cash flows.
Member
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'
Posts: 141 bank whose parent is incorporated in the United States.
Joined: Jul 2002
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?

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