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Background to Currency Swaps

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

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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