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Currency swaps involve the exchange of interest and principal payments in one
currency for similar payments in another currency. Unlike a standard IRS, the
payments for both legs might be based on a fixed interest rate, both might be
floating, or one leg might be fixed and the other floating.
From a valuation point of view, most currency swaps can be handled using the
appropriate set of IRS functions. We can decompose a swap into a position in
two bonds, where one bond is denominated in the 'domestic' currency and the
other bond is denominated in a 'foreign' currency. The fair value of the swap
is then just the net value of the short and long positions, where the value
of the foreign leg is converted into domestic currency terms at the spot exchange
rate.
Consider a swap in which a counterparty has contracted to pay coupons based
on a domestic reference rate and receive coupons based on a foreign reference
rate. The counterparty's position can therefore be characterized as a short
position in a domestic bond and a long position in the foreign currency bond.
The value of the swap (in domestic currency terms) is then:
NPVSwap=NPVFor·X-NPVDom
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| Where: | NPVFor | = value of the foreign bond, expressed in foreign currency terms |
| NPVDom | = value of the domestic bond, expressed in domestic currency terms |
| X | = spot exchange rate, expressed as the number of units of domestic currency per unit of foreign currency |
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