Positions that are of longer term are more often hedged through swap markets than forward markets. The structure of a foreign currency swap is very similar to that of a floating rate interest rate swap. We will take the case of a floating rate ¥1000bn five-year loan with interest paid every three months. In order to hedge the annual interest payments we would enter into a yen–dollar swap agreement with terms as follows: Nominal values of the contracts are ¥1000bn and $1bn. The amount to be paid by the yen payer is set at the current spot yen 90-day interest rate for settlement 90 days after.
The amount to be paid by the US$ payer is set at the current US$ 90 day interest rate for payment 90–days after.
Interest rate parity ensures that the US-based bank has fully hedged the interest payments due from the loan. (This is a simplified example and in practice we would have to look more fully at the pricing basis and payment terms of the loan and take these into account.)
The following, slightly more complex, worked example is of a three-year euro–yen swap. The conditions of the two parties are as follows:
Nominal value. Nominal values of the contracts are ¥500bn and €600m.
Payment calculation. Interest to be calculated on a quarterly basis. Payments by the yen payer are to be based on the spot yen 90-day London interbank rate plus 150 bpts and at the spot euro LIBOR for the euro payer. On the day that the agreement starts the two payments due are calculated based on 90-day yen rates of 0.75% and euro rates of 2.25%, giving payments due of ¥281.250m nd €3.375m.
Settlement. Settlement is to be made 90 days after the date of calculation on a netted basis in US$. The calculated payments are converted into US$ based on the then yen:US$ spot rate of 99.50 and a euro:US$ spot rate of 1.205. The yen payment due is US$2 826 633 while that of the euro payer is $2 800 830. The yen payer pays the difference of US$25 803 to the yen receiver.