Question

Compare and contrast the risk exposures associated with interest rate swaps and currency swaps.

Hint:

Interest rate swaps manage interest rate risk; currency swaps manage both interest rate and currency risks, making them more complex and riskier.

Answer 1

Interest Rate Swaps (IRS) and Currency Swaps (CS) are derivative instruments used to manage different types of financial risks. They differ in the nature of their underlying exposures and the associated risks.

Interest Rate Swaps (IRS)	Currency Swaps (CS)
Involve exchanging fixed and floating interest payments on a notional principal denominated in the same currency.	Involve exchanging principal and interest payments in different currencies.
Primary risk is interest rate risk—the risk that interest rates move unfavorably.	Primary risks include both interest rate risk and currency (exchange rate) risk.
Exposed to counterparty risk if the other party defaults on interest payments.	Exposed to higher counterparty risk due to cross-currency cash flows and principal exchanges.
Less complex as only interest payments are exchanged; principal amount is not exchanged.	More complex since both principal and interest are exchanged, increasing settlement and credit risks.
Used mainly to hedge interest rate fluctuations on debt or investments within a single currency.	Used to hedge exposure to exchange rate fluctuations and interest rate changes across different currencies.
Settlement risk is limited to interest payments.	Settlement risk includes both interest and principal payments, increasing the exposure.

Summary:
While both swaps help manage financial risks, interest rate swaps focus solely on interest rate fluctuations within one currency, exposing parties mainly to interest rate and counterparty risks. Currency swaps involve multiple currencies and exchange of principal amounts, exposing parties to additional currency risk and higher settlement risks.