monetary-policy, usa, crisisI’m reading Crisis Economics: A Crash Course in the Future of Finance by Roubini and Mihm.
In Chapter 6, “The Last Resort”, I came across the following passage:
The IMF was not the only lender of last resort. In addition to its myriad domestic interventions, the [U.S.] Federal Reserve played this important international role, by providing “swap lines.” Under these agreements, the Fed “swaps” dollars for some other central bank’s currency. It thereby enables the central banks to lend out dollars to anyone needing them in their home countries. For example, in April 2009, Mexico activated a $30 billion swap line with the Fed. […]
I’d like to better understand. How do these “swap lines” work from a risk perspective? It isn’t clear to me in the above context who is taking on what risk, if any. Which of the following interpretations is more accurate, or am I off the mark?
The Fed swaps dollars for the foreign currency, and then effectively owns the foreign currency, having given up the dollars at a set exchange rate. i.e. the Fed becomes exposed to foreign currency risk, and other than the arrangement having been made between two central banks, this is effectively a “trade” and the Fed can gain or lose from it.
The Fed swaps dollars for the foreign currency, and there is an agreement that the swap will be closed at some later date (a set date, or an open date?) through some kind of compensating transaction to undo the original amounts swapped. i.e. the Fed is not exposed to foreign currency risk and won’t gain or lose through fluctuation in the foreign currency. Isn’t there still some kind of counterparty risk here, e.g. sovereign default?
Essentially, I’m trying to better understand what kind of exposure the Fed takes on when providing these “swap lines”, and how it may benefit the Fed other than simply providing liquidity to the international market. Thank you.
My background: Not an expert. One undergrad econ course years ago and a few good books since.
It operates more like your second bullet. With the swap the FED exchanges US dollars (USDs) for foreign currency at the current market rate. The swap agreement specifies that the currencies will be swapped back at a specified time in the future at the exact same exchange rate. This is advertised as having no exchange rate risk since the FED will end up with the same amount of dollars it had at the beginning of the swap (and usually a little more since the foreign central bank has to pay interest to the FED for the money it earned while loaning out the USDs).
Although the banks are not exposed to exchange rate risk one of the banks will experience a gain and the other a loss unless the market exchange rate is exactly the same at the end of the swap.
Let's take an extreme example. Let's say the exchange rate at the beginning of the swap is 100 USD = 100 pesos. By the end of the swap the market rate has changed to 100 USD = 100,000 pesos. The FED is going to experience a significant gain since it can purchase 100 USD for only 100 pesos. The foreign central bank will experience a substantial loss since it will receive only 100 pesos for 100 USDs at the end of the swap where if it was exchanging at the market rate it would have received 100,000 pesos.
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