Cross-Currency Swap Valuation and Mechanics

Many companies enter into a CC SWAP transaction to hedge currency exposures, and sometimes also interest rate exposures. This article will explain this transaction’s mechanism and demonstrate a technique for valuing fixed for fixed currency swap. We will also provide you with a download link to a basic valuation model in Excel, as shown in a popular tutorial video.

What is the CC SWAP transaction mechanism?

The underlying transaction is the exchange of loans in different currencies between the transaction parties. Each loan has a defined repayment schedule due to the loan interest rate, the payment dates of interest, and the loan principal.

That is, the parties exchange two streams of payments denominated in different currencies.

A company can replace a loan with a fixed or variable interest rate denominated in currency X, with a loan with currency Y with a variable or fixed interest rate.

Why enter into a CC SWAP transaction?

A common reason to enter into a CC SWAP transaction is when a company has taken out a loan in a currency that is not her functional currency, and to hedge this exposure, the company enters into a CC SWAP transaction.

Another reason to enter into a CC SWAP transaction is to offset exposure which results from foreign currency receipts. For example, suppose a company has foreign currency income denominated in currency X. In that case, she can enter into a CC SWAP transaction and convert an existing loan denominated in the functional currency into a foreign currency X loan. In this way, income in currency X will be used to repay the loan in currency X. This, of course, affects the company’s balance sheet, but it is outside this article’s scope.

At the transaction establishing time, the discounted value of the two cash flows should theoretically be zero. Therefore at the establishment time, there should be no cash flows exchange between the transaction parties. In reality, due to asymmetries in information and other reasons, the transaction’s economic value is not zero and favors the bank. Typically, a non-financial company cannot price the transaction’s economic value or does not work with a sufficient number of banks to create competition between them.

The problems associated with fair value pricing at the transaction creation are all also true for situations in which the company wishes to exit the transaction before it is terminated (unwind). Even during the transaction life, it is required to revalued the instrument at fair value. Expenses on valuers are starting to pile up into significant amounts.

How to value Coss-currency SWAP transactions?

Well, the Cross-Currency Swap Valuation formulas are not rocket science. The main problem is related to obtaining reliable market data as model input. Most CC Swap transactions are executed in the OTC market, making the market data accessible to a relatively homogenous group from the financial sector.

Of course, pricing and information systems can be purchased for a fee, but the cost is usually unthinkable for a company whose financial activity is not its core activity.

Well, what's the second-best?

A custom model in Excel with a reliable market data combination is not a bad alternative. But the mission of finding quality public market data is between an impossible and a challenging task in some cases. In this article, we will focus on the technical aspect of the valuation model. 

Cross-Currency Swap example

The model shown in the tutorial video is available for download in Excel at this link 👉 - Click here. The model is basic but excellent for understanding the mechanism. It should be noted that the technical level of cc swap, which incorporates variable interest rates, is slightly higher.

The model has two sheets, which include two methods of Cross-Currency Swap pricing. The FRAs method valuation model is more common and makes it possible to model relatively quickly market value adjustments (MTM) to CVA/DVA, making it possible to obtain “fair value” according to the accounting rules.

Enjoy!

• Link to download Cross-Currency Swap Valuation excel model for free 👉 - Click here.

• If you want us to build you a custom valuation model and refer you to public market data 👉 - Click here.

Fixed for fixed currency swap: mechanics and valuation

Source: Bionic Turtle