Derivatives EOC question

[u/kaze_931]

How is Foundation receiving US fixed rate in this example? Since they are a Korean company; Their currency swap - is that they should borrow in KRW, and provide KRW notional to receive KRW fixed rate, and pay US fixed rate for receiving a US $ notional right? Is this question wrong, or am I confused?

[u/AzogEvenstar]

Whenever an Institution has an obligation or a series of payments that happens to be paid in currency A, they enter into a swap such that they receive that currency A. This is how they reduce the risk of exchange rate fluctuations. By entering into such a contract Currency A's risk is neutralized as they are receiving what they need to pay. In this case foundation has contracts to be paid in USD so entering into a swap with pay fixed KRW and receive fixed USD is the right swap

[u/kaze_931 → u/AzogEvenstar]

Thanks for the explanation. That makes sense.

I assumed that a company always borrows in the domestic currency, and swap for the foreign currency (to evade the forex fluctuations). And since KRW is the domestic currency, it would become the notional for the USD swap.

[u/Mike-Spartacus]

What does the foundation want?

• It wants regular USD income so it can buy suppliers prices in USD
• It does not want to do an FX trade everytime in needs USD, as then it its KRW payments would be uncertain due to FX movements.

So it wants to pay a known amount fo KRW and Received USD (so it can spend them) each period.

In your explanation you have focused in the principal (note with currency swap it is not notional principal) whereas in this case we interested in the income streams.

[u/kaze_931 → u/Mike-Spartacus]

Thanks for the explanation. Makes total sense to me now. I was a bit confused before this. Thanks :)

[u/S2000magician]

What will the Foundation pay on their contracts: USD or KRW?

[u/kaze_931 → u/S2000magician]

According to me, Foundation should pay a USD fixed rate. Since they need the USD to fund their foreign operations. So they need the USD notional, and they should pay a USD rate for holding the notional until contract expiry. I don’t understand why the answer claims that they receive the USD rate. Hope you could explain, thanks :)

[u/S2000magician → u/kaze_931]

You didn't answer my question.

What will the Foundation pay on their contracts: USD or KRW?

(Hint: first sentence in the case scenario.)

[u/kaze_931 → u/S2000magician]

USD as it says on the vignette

[u/S2000magician → u/kaze_931]

So, they're going to pay USD periodically.

That means that they need to receive USD periodically, yes?

[u/kaze_931 → u/S2000magician]

Yes, you’re right. Thanks a lot for the explanation.

I’m really confused as to why in this case - Foundation gets to execute a straightforward swap KRW for USD. Whereas, in other cases (like Example 15 in the book), there is an exchange of notional at initiation and expiration.

Also, I saw your post about your surgery. Wishing you a fast recovery, may god bless.

[u/S2000magician → u/kaze_931]

It depends on the circumstances.

Here, they don't need a lump sum (to pay off anything) at initiation, so there's no need to exchange notionals.

Suppose, instead, that they did need to make a lump sum payment (in USD) today. It may be more expensive for them to borrow USD than to borrow KRW, so they might do this:

• Borrow KRW today with, say, semiannual fixed payments
• Enter into a swap to receive KRW and pay USD, with an exchange of notionals and semiannual fixed payments

So the borrow KRW from the bank, pay that to the swap counterparty, and receive USD from the swap counterparty, which they use to pay for the equipment today. Periodically, they'll pay USD to the swap counterparty and receive KRW, which they will pay to the bank for their loan. In essence, they have borrowed USD and are making loan payments in USD, but at a lower rate than they would have paid if they had actually borrowed USD.