Currency Swap:

A simple type of currency swap would be an agreement between two parties to exchange
fixed rate interest payments and the principal on a loan in one currency for fixed rate
interest payments and the principal on a loan in another currency. Note that for such a
swap, the uncertainty in the cash flow is due to uncertainty in the currency exchange rate.
In a Dollar/Euro swap, for example, a US company may receive the Euro payments of the
swap while a German company might receive the dollar payments. Note that the value of
the swap to each party will vary as the USD/Euro exchange rate varies. As a result, the
companies are exposed to foreign exchange risk but if necessary this risk can be hedged by
trading in the forward foreign exchange market.

Currency swaps are over-the-counter derivatives, and are closely related to interest rate
swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the
principal.

There are three different ways in which currency swaps can exchange loans:

1. The most simple currency swap structure is to exchange the principal only with the
counterparty, at a rate agreed now, at some specified point in the future. Such an
agreement performs a function equivalent to a forward contract or futures. The cost
of finding a counterparty (either directly or through an intermediary), and drawing
up an agreement with them, makes swaps more expensive than alternative
derivatives (and thus rarely used) as a method to fix shorter term forward exchange
rates. However for the longer term future, commonly up to 10 years, where spreads
are wider for alternative derivatives, principal-only currency swaps are often used as
a cost-effective way to fix forward rates. This type of currency swap is also known as
an FX-swap.
2. Another currency swap structure is to combine the exchange of loan principal, as
above, with an interest rate swap. In such a swap, interest cash flows are not netted
before they are paid to the counterparty (as they would be in a vanilla interest rate
swap because they are denominated in different currencies. As each party effectively
borrows on the other's behalf, this type of swap is also known as a back-to-back
loan.
3. Last here, but certainly not least important, is to swap only interest payment cash
flows on loans of the same size and term. Again, as this is a currency swap, the
exchanged cash flows are in different denominations and so are not netted. An
example of such a swap is the exchange of fixed-rate US Dollar interest payments for
floating-rate interest payments in Euro. This type of swap is also known as a cross-
currency interest rate swap, or cross-currency swap.
Interest Rate Swap:
Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate
specifications) for another. Because they trade OTC, they are really just contracts set up
between two or more parties, and thus can be customized in any number of ways.

Interest rate swaps often exchange a fixed payment for a floating payment that is linked to
an interest rate (most often the LIBOR). A company will typically use interest rate swaps to
limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower
interest rate than it would have been able to get without the swap.

Types:
Being OTC instruments interest rate swaps can come in a huge number of varieties and can
be structured to meet the specific needs of the counterparties. By far the most common are
fixed-for-floating, fixed-for-fixed or floating-for-floating. The legs of the swap can be in the
same currency or in different currencies. (A single-currency fixed-for-fixed rate swap is
generally not possible; since the entire cash-flow stream can be predicted at the outset
there would be no reason to maintain a swap contract as the two parties could just settle
for the difference between the present values of the two fixed streams; the only exceptions
would be where the notional amount on one leg is uncertain or other esoteric uncertainty is
introduced.

Uses:
Interest rate swaps were originally created to allow multi-national companies to evade
exchange controls. Today, interest rate swaps are used to hedge against or speculate on
changes in interest rates.
Interest rate swaps are also used speculatively by hedge funds or other investors
who expect a change in interest rates or the relationships between them. Traditionally, fixed
income investors who expected rates to fall would purchase cash bonds, whose value
increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed
interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the
same fixed rate.
Interest rate swaps are also very popular due to the arbitrage opportunities they provide.
Due to varying levels of creditworthiness in companies, there is often a positive quality
spread differential which allows both parties to benefit from an interest rate swap.

Risks:
Interest rate swaps expose users to interest rate risk and credit risk.
 Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-
for-floating swap, the party who pays the floating rate benefits when rates fall. (Note
that the party that pays floating has an interest rate exposure analogous to a long
bond position.)
 Credit risk on the swap comes into play if the swap is in the money or not. If one of
the parties is in the money, then that party faces credit risk of possible default by
another party.
COVERED AND UNCOVERED INTEREST RATE PARITY:

Interest rate parity is an economic concept, expressed as a basic algebraic identity that
relates interest rates and exchange rates. The identity is theoretical, and usually follows from
assumptions imposed in economic models. There is evidence to support as well as to refute
the concept.

Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in
one currency, exchanging that currency for another currency and investing in interest-bearing
instruments of the second currency, while simultaneously purchasing futures contracts to
convert the currency back at the end of the holding period, should be equal to the returns
from purchasing and holding similar interest-bearing instruments of the first currency. If the
returns are different, an arbitrage transaction could, in theory, produce a risk-free return.

Looked at differently, interest rate parity says that the spot price and the forward, or futures
price, of a currency incorporate any interest rate differentials between the two currencies
assuming there are no transaction costs or taxes.

Two versions of the identity are commonly presented in academic literature: covered interest
rate parity and uncovered interest rate parity.

Example Uncovered vs. Covered interest parity

Let's assume you wanted to pay for something in Yen in a month's time. There are several
ways to do this.
(a) Buy Yen forward 30 days to lock in the exchange rate. Then you may invest in
dollars for 30 days until you must convert dollars to Yen in a month. This is called
covering because you now have covered yourself and have no exchange rate risk.

(b) Convert spot to Yen today. Invest in a Japanese bond (in Yen) for 30 days (or
otherwise loan out Yen for 30 days) then pay your Yen obligation. Under this model,
you are sure of the interest you will earn, so you may convert fewer dollars to Yen
today, since the Yen will grow via interest. Notice how you have still covered your
exchange risk, because you have simply converted to Yen immediately.

(c) You could also invest the money in dollars and change it for Yen in a month.
EXCHANGE RATE:
An exchange rate is the current market price for which one currency can be exchanged for
another.

NOMINAL EXCHANGE RATE:

It is defined as the actual foreign exchange quotation in contrast to the real exchange rate
which can be adjusted for changes in purchasing power.

Mathematical Formulation;

The nominal exchange rate is the price in domestic currency of one unit of a foreign
currency.

e X Pi=Pi*
Where:
• e denotes the nominal exchange rate of the domestic currency in terms of the
foreign currency.
• Pi denotes the price of good i in domestic in domestic currency.
• e X Pi is the price of the same good in domestic in foreign currency.
• *Pi denotes the price of the same good in the foreign in foreign currency.

REAL EXCHANGE RATE:

Basically, the real exchange rate can be defined as the nominal exchange rate that
takes the inflation differentials among the countries into account. Its importance
stems from the fact that it can be used as an indicator of competitiveness in the foreign
trade of a country.

The Real Exchange Rate Definitions:

Purchasing Power Parity: