Week 1: Multinational Corporations (MNCs), Exchange Rate Det termination &

International Monetary Systems

Chapter 1: Multinational Corporations
Multinational corporation (MNC) is a company engaged in producing, selling goods/services in more
than one country
●​ Deglobalisation (Trade war, pandemic, geopolitical conflict)

Theory of Comparative Advantage

Assumptions
●​ Exporters sell undifferentiated goods & services to unrelated importers
●​ It ignores roles of uncertainty, economies of scale & technology in international trade

●​ US is 4x more efficient at producing coal but 1.5x more efficient in wheat -> UK has relative
advantage in producing wheat

MNCs
●​ With specialisation, global GDP is maximised
●​ MNC’s existence is based on international mobility of factors of production & carrying over
skills & resources to other countries
-​ Also relies on firm’s abilities to leverage comparative advantages by moving them
across countries

Rise of MNCs
●​ Knowledge seekers enter foreign markets to gain information
●​ Domestic customer followers trying to deliver services to customers abroad, consulting
firms set up foreign practices following their MNC clients (PWC)
●​ Raw materials seekers go abroad to explore raw material (BHP)
●​ Market seekers go overseas to product & sell in foreign markets (Mcdonald’s)

Chapter 2: Determination of Exchange Rates

Framework
MNCs can reduce their operating risk through international diversification
●​ Countries’ economic cycles vary over time & exchange rate fluctuations are risks
Managing exchange rate risk involves:
●​ Forecasting exchange rates & changes in foreign exchange rates
●​ Hedging exchange rate risk

Terminologies
Revaluation/Devaluation: Value of currency is changed by the government in fixed rate systems
Calculating Exchange Rate Changes
Currency appreciation/depreciation = (New value - Old value)/Old value
●​ Note: %change in AUD/USD doesn't equal % change in USD/AUD

General Determinants of Exchange Rates

Supply & demand for freely floating currencies is driven by 4 factors:
1.​ Relative inflation rates
-​ Inflation = % increase of consumer price index (CPI)
-​ If US inflation increases but AU remains same = US goods more expensive = People
buy AU goods instead of US = Demand for AU increases = AU appreciates, US
depreciates = USD/AUD increases

2.​ Relative (real) interest rates

-​ If US interest rate higher than AU = People want to invest in US = Increase demand =
US appreciates = USD/AUD decreases
 3.​ Relative economic growth (GDP) rates
-​ Higher GDP growth -> Currency appreciates
4.​ Political & economic risk
-​ Higher risk -> Currency depreciates (investors run away)
`
Role of Expectations
●​ For financial assets, prices depend on people’s willingness to hold, which in return depend on
people's expectation on future prices of assets
-​ Therefore, exchange rates are forward looking depending on investors expectations
on ALL determinants of exchange rates

Central Bank Intervention

Have goals of maintaining currency rate stability, they use monetary policy to achieve price level
stability, set interest rates, or directly purchase/sell currencies on international currency markets
●​ Independent central banks have better reputation
●​ Dependent central banks often forced to monetise government deficits -> print money etc

Type of Central Bank Intervention

Purchases/sales of currencies to influence domestic currency
●​ Unsterilised intervention:
-​ ECB want to let USD/EUR depreciate -> increase supply of EUR or increase demand
for USD = Buy USD in exchange for EU = EU supply increases = Inflation increases
●​ Sterilised intervention: Neutralise inflation
-​ Open market operations to keep money supply constant by buying/selling treasury
securities

Chapter 3: The International Monetary System

Central Bank Has 3 Objectives

Exchange Rate Systems

 Floating Currency Fixed/Pegged Target-Zone Crawling Peg
Currency Arrangement

Free float: S&D Target exchange rate Market forces within Currency depreciation
set by govt, with margin around agreed against reference
Dirty float: Market central bank upon fixed exchange currency on regular
forces with some intervention if deviates rate controlled basis ->
central bank Used to ease
intervention Requires coordinated transition from fixed to
monetary policies fluctuating exchange
Managed floating rate
currencies: More
central bank
intervention than dirty
float

Free (Clean) Float

Determined by supply & demand forces: Inflation, interest rates & eco growth
●​ Helps stabilise economy -> Negative shock -> Lower exchange rate -> Higher exports
●​ More economic volatility & risky business decisions

Dirty Float
Determined by market forces with some central bank intervention
●​ Smooths out temporary fluctuations by buying/selling currency on open market

Managed Float
More central bank intervention than in a dirty float
●​ Smooth out temporary fluctuations by buying/selling on open market

Fixed/Pegged Rate
Target exchange rate set by government, with central bank intervention
●​ Reduces economic volatility, benefits trade & investment
●​ No monetary independence - requires coordinated monetary policies
●​ E.g. Of fixed rate is dollarization: Replacing local currency with USD

Target Zone Arrangement

Determined by market forces within margin around agreed-upon fixed exchange rates
●​ Allows for some exchange rate fluctuations
●​ Intervention to maintain rates within margins

Crawling Peg
Local currency depreciates against reference currency on a regular, controlled basis

Week 2: Foreign Exchange Markets and Parity Conditions

Chapter 6: FX Markets
A decentralised space (Traded in more than one place)
●​ The FX market facilitates purchasing power denominated in one currency to be obtained
●​ E.G Individual sells USD for Chinese Renminbi = Individual is selling USD denominated
purchasing power & buying Renminbi denominated purchasing power

Contracts Traded On FX Market

●​ Spot contracts: Currencies traded for immediate delivery
●​ Forward contracts & futures: Buying/selling currencies for future delivery
 ●​ Swap contracts: Combination of spot contract & forward contract
●​ Derivatives: Contract that derive value from changes in underlying asset's value

Spot Market
FX Rate Quotations
●​ Direct Quote: Quoting domestic currency first
●​ Indirect Quote: Quoting foreign currency first

Bid Exchange Rate & Ask Exchange Rate

Bid: The most that the market maker is willing to buy the base currency
Ask: The least that the market maker is willing to sell the base currency

Bid Ask Spread

Why do we have different bid & ask rates?
●​ Market maker buys forex at bid rate (low) & sell at ask rate (high)
●​ Bid-ask spread is commission received by market maker for providing liquidity (Bid-ask
spread is the transaction costs for us)
●​ Therefore, bid exchange rate < ask exchange rate

Bid Ask Spread = Transaction Cost

Vehicle Currency & Cross Rates
●​ Vehicle Currency: Currency that is actively used in many international financial transactions
around the world
●​ US Dollar primary vehicle currency (89% of all transactions)
●​ E.G If 1 EUR = 1.47 USD and 1 SFR = 0.98 USD, what should be SFR/EUR?
-​ USD/EUR = 1.47USD/EUR and USD/SFR = 0.98USD/SFR
-​ SFR/EUR = (1.47USD/EUR) / (0.98USD/SFR) = 1.5 SFR/EUR

Triangular Arbitrage
The result of discrepancy between 3 foreign currencies that occur when exchange rate of currency
does not match cross exchange rate
●​ Price discrepancies arise from when one market is overvalued & one is undervalued

●​ If cross multiplication is equal to 1 -> No arbitrage opportunity

●​ If cross multiplication is NOT equal to 1 -> Arbitrage opportunity exists
Indirect Method
Forward Market
Hedging Using Forward Contracts
●​ Forward contract: Contract to deliver specified amount of currency at fixed future date at fixed
exchange rate
-​ Forward rates are market’s estimate of spot rate at specific date in future
-​ Locks in rate for future transaction, eliminates uncertainty
●​ HIgher bid-ask spreads than spot market
-​ Higher for greater maturities

Participants in FX FW Market
●​ Traders, Hedgers, Speculators, Arbitrageurs

Forward Quotations & Swap Rates

When we want to compare forward rates with spot rates, we want to see if base currency is at forward
premium or discount
●​ If forward rate > spot rate = Forward premium
●​ If forward rate < spot rate = Forward discount

This is annualised rate

Chapter 4: Parity Conditions In International Finance & Corporate Forecasting
Parity Conditions
●​ Set of theoretical relationships that in equilibrium, explain product prices, interest rates & spot
& forward exchange rates

Price Level & Price Index

●​ Price level at given time is calculated as weighted average of prices of goods & services
consumed in a country
●​ Price index at time t is price level in the year calculated against the level in base year, t=0

Law Of One Price

●​ Because of arbitrage, exchange rate adjusted prices of equivalent goods & assets must be
equal worldwide
●​ A direct application of the Law of One Price to national price levels: Absolute Purchasing
Power Parity (PPP)
-​ Theory that suggests that exchange rate between two countries will adjust to ensure
basket of g+s costs the same in both countries when expressed in a common
currency
-​ According to APPP, if price level increases in one country relative to another, the
exchange rate between their currencies should adjust accordingly to reflect this
change (However APPP fails to account for transportation costs, tariffs etc)

Absolute Purchasing Power Parity (APPP)

Internal Purchasing Power & External PP

Price Level & Purchasing Power of Currency

If internal purchasing power does not equal external purchasing power, arbitrage opportunity exists
●​ If external PP > Internal PP > Overvalued currency
-​ Overvalued currencies must weaken (depreciate)
●​ If internal PP > External PP > Undervalued currency
-​ Undervalued currencies must strengthen (appreciate)
●​ In equilibrium, internal PP = external PP > Absolute PPP
Comparing the PPP implied spot rate with spot rate
We need to calculate PPP rate to see if currency is overvalued or undervalued
●​ If PPP implied spot rate > Actual spot rate on FX market, then currency being expressed is
undervalued > We expect base currency to appreciate
●​ If PPP implied spot rate < Actual spot rate on FX market, then currency being expressed is
overvalued > We expect base currency to depreciate
●​ If PPP implied spot rate = Actual spot rate on FX market = Currency expressed is fairly valued
= No appreciation or depreciation

Relative Purchasing Power Parity (RPPP)

●​ Suggests that changes in exchange rates between two currencies over time should reflect
changes in the price levels between the two countries
-​ Doesn’t require actual rate = PPP rate
-​ Equal rates of change are sufficient for relative PPP to hold
●​ Increasing price level (decreasing purchasing power): Inflation
●​ Decreasing price level (increasing purchasing power): Deflation

Generalised RPPP Equation

●​ This expression of RPPP is general &
allows for both constant & non-constant
expectations of rate of inflation in a country
Real vs Nominal Exchange Rates
●​ PPP states that changes in exchange rates should cancel out changes in relative price levels
between two countries
●​ Changes in nominal exchange rate only reflect inflation differentials between countries
Week 3: Parity Conditions Fisher Effect, Interest Rate Parity & Forecasting
Chapter 4: Parity Conditions in International Finance & Corporate Forecasting
Purchasing Power Parity (PPP)
Fisher Effect (FE)

Fisher Effect describes relationship between inflation & both real and nominal interest rates
●​ Nominal interest rate reflect rate of exchange between current & future money excluding
factors of expected inflation
●​ Real interest rate accounts for effects of inflation & measures rate of purchasing power
overtime
FE states that nominal interest rate r is made of 2 components:
1.​ Real required rate of return a (Real interest rate)
2.​ Expected inflation i
FE - Real Interest Rates Across Countries
Nominal interest rate differential must equal anticipated inflation differential
●​ Currencies with higher rates of inflation should have higher nominal interest rates than
currencies with lower rates of inflation

International Fisher Effect (IFE)

PPP: Exchange rate changes <-> Changes in inflation rate differentials
●​ Rise in Australian inflation rate relative to other country will decrease value of AUD
FE: Expected inflation rate differentials <-> Nominal interest rate differentials
●​ Rise in Australian inflation rate will increase Australian nominal interest rates
IFE = PPP + FE: Exchange rate changes <-> Nominal interest rate differentials
●​ Rise in Australian interest rate relative to other country will decrease value of AUD
Generalised IFE (Similar to RPPP)
We can assume that expectations of inflation rates are
constant
●​ Expression of IFE is general & allows for constant &
non constant expectations of rate of inflation in a
country

Interest Rate Parity (IRP)​

(1) IFE says that nominal interest rate differential should equal expected change in exchange rate
(2) Forward rates are market’s estimate of spot rate at specific date in future
-> IRP states that interest rate differential should equal to spread between spot & forward exchange
rates
 ●​ Currency of country with lower interest rate should be at forward premium in terms of
currency of country with higher rate
●​ This ensures that return on domestic investment = Return on hedged foreign investment
of identical risk
●​ Notion of Covered Interest Rate Parity (CIRP)

Generalised CIRP
No reason to assume nominal interest rates are
constant per period
●​ Expression of CIRP is general & allows for
both constant & non constant expressions of
rate of inflation in country
Understanding One Period CIRP
Generalised UIRP
No reason to assume nominal interest rates are
constant per period
●​ Expression of UIRP is general & allows for
both constant & non constant expectations of
rate of inflation in country

Unbiased Forward Rate (UFR)

Forward rates will be an unbiased predictor of future spot

rate when market form unbiased expectations of future spot
rate & speculators trade forward contracts at prices equal to
market expectations
●​ Investments involve risk, speculators demand
premium for holding forward contract
●​ Sufficient to have market efficiency (No arbitrage)
-​ Forward rate will then not exactly equal expected future spot rate
-​ Rather, forward premium/discount will equal expected spot rate change

UFR in Reality
Empirically, UFR does not hold up very well
●​ Profitable carry trade by hedge funds: go long in foreign currencies that trade at discount and
go short in currencies that trade at a premium
●​ Sometimes anticipated events don’t materialise invalidating statistical evidence

Week 4: Currency Futures & Options

Chapter 7
Value Of Firm
Principle of firm valuation:
●​ Value of firm = Discounted future cash flow
●​ Firm has 2 sides: Operating & Financing

Financial Derivatives
●​ Financial contracts whose value is based on an underlying asset (currency)
-​ Can be used to hedge foreign exchange risk

Foreign Currency Forward Contracts

Currency Forward
●​ You are buying foreign currency when purchasing forward contracts
●​ Forward Contract: Contract to deliver specified amount of currency at fixed future date & at
a fixed exchange rate (forward rate)
 ●​ Forward rate is market’;s estimate of the spot rate at settlement date of forward contract
●​ Forward contracts are over the counter (OTC) contracts (Privately negotiated between 2
parties)

Key Characteristics Of Forward Contract

Maturity: Negotiated (Usually 30, 60, 90)
Amount: Negotiated
Fees: Bid-ask Spread
Settlement: At maturity
Default Risk: High
Collateral: Negotiated
Hedging: Perfect -> Can be tailored to buyer/seller’s exposure
Foreign Currency Future Contracts
Currency Forwards & Futures
●​ Both contracts give parties obligation to buy/sell particular currency at predetermined date at
predetermined fixed price
●​ Contract must specify: Futures are standardised contracts
-​ Quantity of available currency
-​ Fixed exchange rate
-​ Set delivery date
●​ Futures contract is exchanged based contract where exchange is counterparty
●​ Futures contracts operate through an exchange: CME, LIFFE etc
Accounts Payable
●​ From perspective of MNC, this is future outflow of foreign currency -> To hedge this risk, MNC
must buy future contracts
Accounts Receiveable
●​ From perspective of MNC, this is future inflow of foreign currency -> To hedge this risk, MNC
must sell future contracts

Foreign Currency Accounts Payable

Foreign Currency Accounts Receivables

Margin Requirements
Marked to market: Losses & profits recognised on daily basis (Daily settlement)
●​ Investors deposit certain amount in margin account
●​ Initial deposit is initial margin (Usually less than 3% of contract value)

Maintenance of margin account balance

 ●​ As guarantee fund to prevent default
●​ Margin call if loss on contract > maintenance margin
●​ Maintenance margin is usually set as % of initial margin

At the end of trading every day future investors must pay over any losses or gains from day’s price
movements -> Daily settlement reduces default risk of futures contracts relative to forward contracts
●​ An insolvent investor with unprofitable position would be forced into default after one day’s
trading rather than losses being accumulated until contract matures

Futures: Pros & Cons

Pros Cons

●​ Easy to liquidate & trade ●​ Standardised contract sizes

●​ Limited counterparty risk ●​ Not available for all currencies

Foreign Currency Options

Currency Option Contracts
Future & forwards protect against adverse changes in exchange rates, but also remove potential of
benefitting from favourable changes
●​ Currency options provide BOTH: Hedges against exchange rate risk, while leaving
opportunities open to benefit from favourable changes

Currency options gives holder (buyer) the right but not the obligation to buy or sell a specified
amount of a particular currency at a predetermined exchange rate (the strike price) on or before a
specified expiration date
●​ In exchange, option buyer pays premium to option writer (seller)
●​ Call option gives right to buy pre-specified currency
●​ Put option gives right to sell pre-specified currency

Characteristics of Options
Expiration dates (Maturity):
●​ American option - exercise can happen at any time until expiration date
●​ European option - exercise can only happen at expiration date
Price of option:
●​ Premium paid by buyer of option to seller

Exercise price/Stock price:

●​ Pre-specified exchange rate at which parties will transact

Hedging with Currency Option Contracts

●​ Intrinsic value of an option defined as monetary value of option if it exercised today -> Known
as “moneyness” -> Does not equal profit made on currency option
●​ Intrinsic value is positive if option is in the money:
-​ Call option: Spot price S - Strike Price K
-​ Put option: Strike price (K) - Spot Price (S)
●​ Intrinsic value = 0 if option is at the money or out of the money

Currency Option Example 1 - Seek Lecture Slides

Value of an Option - Terminologies

In the money (Profit from exercising option at current spot rate)
-​ Call option: spot > strike
-​ Put option: spot < strike
Out of the money (loss from exercising option at current spot rate
-​ Call option: spot < strike
-​ Put option: spot > strike
At the money
-​ Spot = strike
Intrinsic Value - Amount in the money if exercised today
-​ Call option: = spot price - strike price (S - K)
-​ Put option: = strike price - spot price (K - S)
-​ Intrinsic money = 0 when the option is out of or at the money
-​ Represents what it would be worth if the buyer exercised option at current point in time (not
same as profit)
Time Value - Time to maturity
-​ An additional amount an investor is willing to pay over the current intrinsic value (always
positive for American options)
-​ Represents possibility that option will increase in value before expiration date

Future Contracts vs Options Contracts Example - Seek Lecture Slides

When Best to Use Forwards & Futures or Options?

General rules to follow for hedging cash flows are:
●​ Known amount of foreign currency cash outflow -> Buy foreign currency forward
●​ Known amount of foreign currency cash inflow -> Sell foreign currency
●​ Unknown amount of foreign currency cash outflow -> Buy foreign currency
●​ Unknown amount of foreign currency cash inflow -> Buy foreign currency put option
●​ Mix of known & unknown currency amounts:
-​ Hedge the known amount using forwards
-​ Use options to hedge the unknown amount
Week 5: Swaps & Managing Exposure
The Value of a Firm
●​ Principle of firm valuation:
-​ Value of a firm = Discounted future cash flow

Managing Foreign Exchange Exposure

Firms face 3 type of foreign exchange exposure
Translation Exposure
●​ AKA accounting exposure/balance sheet exposure
●​ Exposure from need to convert financial statements of foreign subsidiaries from local
currencies to home (parent) currency when reporting & consolidating
●​ Real cash flow doesn’t change
Transaction Exposure
●​ Risk of exchange rate fluctuation between now (sign contract) & transaction settlement
●​ Prospective & retrospective: Based on future cash flows from contracts entered into past
Operating Exposure
●​ Exchange rate fluctuation will affect future cash flows from contracts entered into past
●​ Prospective in nature: Based on estimated future cash flows

Transaction Exposure + Operating Exposure = Economic Exposure

Economic Exposure: Arises when exchange rate changes on the value of FUTURE revenues
and/or expenses, thus firm value

Managing Transaction Exposures

Management of foreign currency exposure centres on concept of hedging
●​ Establishing an offsetting currency position so that loss/gain on original currency exposure is
exactly offset by corresponding foreign exchange gain/loss on currency hedge
●​ Aims to reduce/eliminate volatility in earnings due to exchange rate changes
●​ Should be considered a cost/equivalent to buying insurance
Forward Market Solution
●​ GE can enter into forward contract in opposite direction of cash flow
●​ At forward rate of USD 1.479/EUR, GE can lock in receipt of USD 14.79m
●​ Downside: If spot rate increases, then GE only receives USD 14.79m

Money Market Hedge

An alternative to forward market hedge
●​ Lock in (domestic currency) value of future foreign currency cash flow by borrowing & lending
at the same time in 2 different currencies
●​ CIRP: Forward contract can be replicated via money market transactions
●​ Money market hedge can be seen as ‘synthetic forward’

For an EXPORTER (Foreign currency receivable):

1.​ Borrow sum equal to present value of receivable in foreign currency today
2.​ Convert borrowed amount into domestic currency
3.​ Invest that converted sum into domestic money market
4.​ Obtain accounts receivable (In domestic currency)
5.​ Retire outstanding loan amount using receivable

For an IMPORTER (Foreign currency payable):

1.​ Borrow a sum equal to the present value of the payable in the domestic currency today
2.​ Convert the borrowed amount into foreign currency
3.​ Invest that converted sum into the foreign currency money market
4.​ Use the proceeds from the investment to settle the accounts payable
5.​ Retire the outstanding loan amount
Risk Shifting
Avoid transaction exposure by invoicing in home currency
●​ Risk is shited to counterparty - zero sum game
●​ Common in international business transactions
Firms tend to invoice exports (income) in strong currencies, & imports (expenses) in weak currencies
●​ ‘Strong’ currencies are those whose value is expected to appreciate against others
●​ ‘Weak’ currencies are those whose value expected to depreciate against others

Risk Shifting Solution:

●​ If GE invoices in USD, then Lufthansa will not be willing to pay more than the equivalent value
of 𝐸𝑈𝑅10𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
●​ Lufthansa can buy USD forward, resulting in a payment of 𝑈𝑆𝐷14,790,000

Currency Risk Sharing

Currency Collars
●​ Designed to hedge against adverse currency movements outside
agreed-upon range
●​ Exchange rate changes within range are accepted as it -> However, changes outside of range
are limited to upper & lower boundaries
●​ Exposure converted at rate forward
Hedging with Options
Previous strategies are useful for known currency exposures
Exposure Netting
Offsetting asset exposures in one currency with liability exposures in the same or another (positively
correlated) currency
3 Possibilities:
1.​ Offset long position with short position in same currency
2.​ If 2 currencies are positively correlated, offset long position in one with a short position in the
other
3.​ If two currencies are negatively correlated, short (long) positions in both currencies
E.G.
●​ Offsetting an AUD 3.4 million receivable with an AUD 3.4 million payable
●​ Offsetting an AUD 2.7 million receivable with a CAD 2.7 million payable (if AUD and CAD
have a high positive correlation)
●​ Offsetting an AUD 5 million receivable with a MXN 5 million receivable (if AUD and MXN have
a high negative correlation)

Cross Hedging
When hedging with futures, exact futures contract required may not be available
●​ Cross-hedge by using futures contracts on available, correlated currencies
●​ To set up cross hedge, necessary to estimate historical correlation between two currencies
-​ Higher correlation, more effective the hedge
Operating Exposures
●​ Extent to which exchange rate changes cause changes in future operating cash flows
●​ E.G. At the beginning of 2002, the USD/EUR rate was about USD0.86/EUR. By mid-2003, it
had risen drastically to USD1.15/EUR -> Implications of dramatic rise: Profits for EU exporters
declined, profits for goods competing with US imports declined
●​ Operating exposure depends on changes in real exchange rate:
-​ If nominal rates change with equal change in price levels -> no cash flow risk
-​ If real exchange rate change -> Purchasing power changes -> Affects
competitiveness

Real vs Nominal Exchange Rates

●​ Real exchange rate depreciation: Makes exports & import-competing goods more
competitive
-​ If importers keep same price, lose sales to domestic competitors
-​ If importers adjust price to remain competitive, narrow profit margin
●​ Real exchange rate appreciation: Makes imports & export competing goods more
competitive
-​ If exporters maintain prices, they lose sales to foreign competing goods
-​ If exporters adjust prices, profits decrease
●​ Ultimately, exposure is determined by relative price changes
Operating Exposures - Solution
Impact of real rate changes on operating exposure depends on pricing flexibility
●​ Price elasticity of demand -> Lower price elasticity = More price flexibility
●​ Degree of differentiation -> More differentiations, less competition = Lower price elasticity
●​ Ability to shift production & sourcing of inputs across countries

Chapter 8: Managing Debt Financing Costs

Swap
An agreement between two counterparties to exchange cash flows at pre-specified future times
according to pre-specified conditions
2 types of swap:
●​ Interest rate swaps -> Coupon swap, basis swap
●​ Currency swaps -> Fixed for fixed, fixed for floating

Interest Rate Swap

●​ Allows MNC to change nature of its debt from fixed interest rate to floating interest rate from
floating interest rate to fixed interest rate
●​ AN agreement between 2 parties to exchange interest payments in same currency for specific
maturity on an agreed upon notional amount
-​ Maturity: Ranges from < 1 year to > 15 year, but typically 2-10 years
 -​Notional amount/principal: Reference amount to calculate interest payment, but
principal never repaid
●​ No exchange of principal is necessary because principal is equal amount of same currency

Interest Rate Swap

2 Types:
Coupon Swap: One party pays fixed rate as a spread on Treasury bond while other party pays floating
rate
●​ Reduces costs if perceived credit quality differs across markets -> Driven by differences in
information & risk aversion
●​ Some default risk: Depends on presence of intermediary
Basis Swap: Two parties pay floating rates against different reference rates
●​ Reference Rate:
-​ Historically LIBOR (London INterbank Offered Rate), Today SOFR (US Secured
Overnight Financing Rate), Another SONIA (sterling Over Night Index Average)

Currency Swap
Agreement between 2 parties to exchange cash flows of two long term bonds denominated in different
currencies
●​ Both parties borrow in their home currency & swap their future cash flow obligations with
counterparty
-​ Cash flow = Principle + Interest Payment
 -​ The counterparties also exchange principal amounts at start & end of swap
arrangement
●​ Currency swaps intended to reduce interest rate risk & currency risk
●​ Each party typically would have comparative advantage in borrowing money using home
currency (Can be fixed-fixed or fixed-float)
Fixed For Floating Swaps
Combines currency swap & interest swap
●​ Converts liability in one currency with specific type of interest payment into liability in another
currency with different type of interest payment
Most Common: Fixed for floating currency swaps
●​ Similar to doing fixed for fixed currency swap with fixed for floating interest rate swap

Interest Rate Derivatives:

●​ Used to management interest rate expense & risk by locking in interest rates on future loans
& deposits

Forward Forward Contracts

●​ A contract in which two parties agree to enter into loan agreement at future time
●​ Contract fixes an interest rate today on future loan or deposit -> Interest rate is hedged
Forward Forward Contract stipulates following particulars:
●​ Principal
●​ Interest Rate
●​ Commencement date of future interest period & ending date of future interest period
Loan agreement requires borrower to repay principal amount upon maturity of loan, along with
premium interest -> Although forward forwards do not involve periodic interest payments, premium
(interest) paid at end of contract effectively compensates lender for risk involved in providing loan
Forward Rate Agreement (FRA)
●​ An agreement to pau certain rate of interest on specific amount (notional principal)
undertaken in future period
-​ OTC between party & bank
-​ Settles in cash at beginning of forward period
●​ Similar to forward forward but only exchange interest payments

Eurodollar Futures
●​ Is a cash settled futures contract on 3 month, USD1 million Eurodollar deposit that pays
LIBOR
●​ These contracts are traded for March, June, September & December delivery -> Contracts
are traded out to three years, with a high degree of liquidity out to two years