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Currency Swaps, Financial Arbitrage, and Default Risk

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  • Nilufer Usmen

Abstract

This paper constructs a model for measuring the gains realized by both counterparties to a currency swap that takes place in an international market in which financial arbitrage opportunities exist. Conditions are derived for zero-sum and nonzero-sum outcomes for both default-free swaps and risky swaps in terms of state-contingent interest rate/exchange rate parities. In an imperfect international capital market, swaps with default risk can give rise to greater gains than a default-free swap. Possibility of default, state by state, becomes a screening device for favorable and unfavorable exchange rate outcomes for each counterparty. Thus, the possibility of default, per se, is not the sole determinant of the degree of credit risk in a swap agreement. Covariability of exchange rates and default states plays an offsetting role.

Suggested Citation

  • Nilufer Usmen, 1994. "Currency Swaps, Financial Arbitrage, and Default Risk," Financial Management, Financial Management Association, vol. 23(2), Summer.
    • Handle: RePEc:fma:fmanag:usmen94
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    Cited by:

    1. Goswami, Gautam & Nam, Jouahn & Shrikhande, Milind M., 2004. "Why do global firms use currency swaps?: Theory and evidence," Journal of Multinational Financial Management, Elsevier, vol. 14(4-5), pages 315-334.

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