Question

Examine the risks of interest rate and currency swaps of a country.

Answer 1

In case of foreign country investment, there is a risk of interest rates which would be prevalent in that country. For example, US investment into India may have an exposure to the prevailing interest rates in the Indian market, as an increase in the interest rates in India increases the overall cost of capital in the country and thus investment projects being evaluated in the country tend to now have a higher discount rate. Also, an increase in interest rate might lead to foreign investment coming into the country, thus leading to an appreciation of the currency which again exposes the foreign investor to a currency risk. This currency risk can be hedged through a currency swap which is an arrangement with a bank wherein the bank would pay the notional principal and interest to the foreign investor at a fixed currency conversion and receive the variable currency payout in return. The risk with currency swap is that in a volatile foreign exchange environment, the cost of currency swap may be prohibitive for a prudent risk management framework.