Financial news

An asset whose payments are not in the domestic currency of the investor has unknown cash flows in the domestic currency. The cash flows in the investor’s domestic currency are dependent on the exchange rate at the time the payments are received from the asset. For example, suppose an investor’s domestic currency is the U.S. dollar and that the investor purchases an asset whose payments are in euros. If the euro depreciates relative to the U.S. dollar at the time a euro payment is received, then fewer U.S. dollars will be received.
The risk of receiving less of the domestic currency than is expected at the time of purchase when an asset makes payments in a currency other than the investor’s domestic currency is called exchange rate risk or currency risk.

We have already alluded to the similarity between swaps and assets. For example, a currency swap is identical to issuing a fixed- or floating-rate bond in one currency, converting the proceeds to the other currency, and using the proceeds to purchase a fixed- or floating- rate bond denominated in the other currency. An interest rate swap is identical to issuing a fixed- or floating-rate bond and using the proceeds to purchase a floating- or fixed-rate bond. The notional principal is equivalent to the face value on these hypothetical bonds.
Equity swaps appear to be equivalent to issuing one type of security and using the proceeds to purchase another, where at least one of the types of securities is a stock or stock index. For example, a pay-fixed, receive-equity swap looks like issuing a fixed-rate bond and using the proceeds to buy a stock or index portfolio. As it turns out, however, these two transactions are not exactly the same, although they are close. The stock position in the transaction is not the same as a buy-and-hold position; some adjustments are required on the settlement dates to replicate the cash flows of a swap.
The equivalence of a swap to transactions we are already familiar with, such as owning assets, is important because it allows us to price and value the swap using simple instruments, such as the underlying currency, interest rate, or stock. We do not require other derivatives to replicate the cash flows of a swap. Nonetheless, other derivatives can be used to replicate the cash flows of a swap, and it is worth seeing why this is true.