What is basis point adjustment? Why is it not appropriate simply to add the basis point differential associated with the first currency to the quoted swap rate that the firm will pay?

Question

What will be an ideal response?

Answer 1

If a customer wants the financial intermediary to do a currency swap in which the financial intermediary will pay the interest and principal on the customer's outstanding bond, which has an interest rate that is different from the interest rate that the intermediary is quoting, the financial intermediary will also have to adjust the basis points on the cash flows of the currency in the swap that the customer is paying. One cannot simply add the additional basis points that the financial intermediary is paying to the rate that the customer will pay, if the levels of the interest rates on the two currencies are different, because a basis point in the future for a currency that is depreciating in value is worth less than a basis point in the future for a currency that is appreciating in value. The correct procedure requires that one take the present value of the extra interest rate payments that the financial intermediary is paying in one currency, convert that amount into the currency that the customer is paying with the spot exchange rate, and determine the additional level payments of the new currency that would have that present value.