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Why FX Swaps Have Interest Rate Risk

Article Quant Q&A · Author: lakshmen
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Summary

The document explains that an FX swap carries interest rate exposure because its cash flows can be viewed as borrowing in one currency and lending in another. Changes in rates in the two currencies can alter the value of the locked-in funding terms, so the swap is exposed to movements in the interest rate differential as well as to spot exchange rates.

A second explanation treats the swap as a sequence of FX forwards. Interest rate parity links forward exchange rates to spot FX and the relevant interest rates, which connects rate spreads to swap value. The discussion also notes that equivalent currency deposits and loans provide an arbitrage-based way to understand the cash flows. These are qualitative explanations; the document gives no pricing formula, worked numerical example, or treatment of valuation details such as collateral or basis effects.

Key ideas

  • An FX swap can be interpreted as borrowing one currency while lending another.
  • Changes in the two currencies' interest rates affect the value of the agreed funding terms.
  • FX forward rates depend on spot exchange rates and the interest rates for each currency.
  • Deposit and loan cash flows help explain the relationship between FX swaps and money markets.

Tags

ForexFixed incomeDerivatives pricingArbitrage
Full text
# Why do FX Swaps have Interest Rate Risk?


# Why do FX Swaps have Interest Rate Risk?












I know that FX Swaps have FX Risk, but why do FX Swaps have Interest Rate Risk as well?

Need some guidance on this.

## Answer by Alex C (score 9, accepted)

https://quant.stackexchange.com/a/29635

An FX Swap can be described as "borrowing in one currency and lending in another". When put this way it is clear that it has something to do with interest rates in the two currencies. You will be very happy if the i.r. in the currency borrowed rises and the i.r. in the currency lent falls the day after you do the deal, because you will have locked in more favorable rates for the term of the swap. So in that sense it is a bet on rates (more specifically on the difference in rates).

## Answer by Mats Lind (score 5)

https://quant.stackexchange.com/a/29630

Looking at the swap as a series of forwards, considering then that the arbitrage-free FX forward depends (via the so called interest rate parity) both on the FX spot and the interest rates for the terms and currencies involved; gives that both spot FX and IR spread impacts the FX swap.

## Answer by rupweb (score 0)

https://quant.stackexchange.com/a/29634

You can structure an FX swap in terms of money market deposits and loans and vice versa. Say you've got AUDSEK 1 year. The AUDSEK FX swap cash flows have to equal the cash flows you'd get on AUD deposits or loans versus SEK deposits or loans, depending on which way round you buy or sell the swap. Otherwise there's interest arbitrage between the FX markets and the money markets. The interest on deposits or loans in different currencies is all about the rate you will give for a deposit or take for a loan in the given currency for the 1 year, priced according to the competition between providers in the money markets. Go figure. Also check out http://www.webstersystems.co.uk/fxmm.htm#interest%20arbitrage

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.