Question

Critically assess the additional challenges of performing a currency swap with a foreign organization relative to a domestic interest rate swap.

Answer 1

In currency swap, the principal or notional amount needs to be exchanged twice-one at the time of initiation and the other art the time of maturity. However, in interest rate swap notional amount is not exchanged. Due to principal exchange, the foreign exchange is an additional risk-market risk. In domestic interest rate swap, one can do a better due diligence than a foreign organization. So the counterparty risk might be higher in foreign organization, which is not captured due to lack of information-credit risk. Also counterparty might have higher incentive to default when exchange rate moves against them. Coupled with foreign exchange risk and counterparty risk , there is also a geopolitical/regulatory risk and therefore currency swap is much riskier than domestic interest rate swap.