Post on 04-Jun-2018
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Currency swaps
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DefinitionA swap is a derivative contract equivalent to a bundle offorward contracts
Swaps are designed to take advantage of the QualitySpread Differential- QSD
QSD arise whenever there is a comparativeadvantagesituation
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Exemplification: Alpine SkiAlpine Ski Inc. is a Swiss manufacturer of sporting goods. It needs to borrow $2 m tobuy supplies and raw material from the United States.
Southern Inc. is a U.S. manufacturer of electronic equipment. It needs to borrow SFR2.8 m to buy electronic components from Switzerland.
Southern is relatively unknown in the Swiss market.
The two companies decide to use a dealerto enter a foreign currency swap.
One-year borrowing rates:Switzerland (SFR) United States ($)
Alpine Ski Inc. 7.5% 9.875%Southern Inc. 8.5% 10%
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Note
Alpine has an absolute advantageat borrowing ineither USA or Switzerland because it is better known
Alpine has a comparative advantageat borrowing athome
Southern has a comparative advantageat borrowingat home
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QSD calculation
QSD = [8.5% - 7.5%] - [10% - 9.875%] = 0.875%
QSD = 87.5 basis points
Switzerland (SFR) United States ($)Alpine Ski Inc. 7.5% 9.875%Southern Inc. 8.5% 10%
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Splitting the QSD
The 87.5 basis points have to be divided among Alpine,
Southern, and the dealer.
The dealer is quoting the swap, hence it has morepower over how the QSD is split
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The onset
Swisscreditors US creditors
Dealer
AlpineSouthern
SFR2.8 m
at 7.5%
SFR2.8 m
SFR2.8 m
$2 m at 10%
$2 m
$2 m
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Interest payments
Swisscreditors US creditors
Dealer
AlpineSouthern
SFR 0.21 m
$0.195 m
$0.2 m
$0.2 m
SFR 0.224 m
SFR 0.21 m
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Repayment of the principal
Swisscreditors US creditors
Dealer
AlpineSouthern
SFR2.8 m
SFR2.8 m
SFR2.8 m
$2 m
$2 m
$2 m
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AnalysisAlpine Ski Inc. borrows $2 m and pays $0.195 m ininterest, that is 9.75%.Southern Inc. borrows SFR2.8 m and pays SFR0.224 min interest, that is 8%.
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The dealer
Pays: - ($195,000 - $200.000) = $5,000
Receives: (SFR224,000 - SFR210,000) = SFR14,000
As long as e < SFR2.8/$ the dealer makes a net gain
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Summary
Alpine
Southern
Dealer
Gets 12.5 basis points
Gets 50 basis points
Gets 25 basis points
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Example 2A US MNC desires to finance a capital expenditure of its Germansubsidiary. The project has an economic life of five years. The costof the project is 40,000,000. The German subsidiary would be
expected to earn enough on the project to meet the annual dollardebt service and to repay the principal in five years.
Assume a German MNC of equivalent creditworthness has amirror-image financing need. It has a US subsidiary in need of $
25,000,000 to finance capital expenditure with an economic life offive years. The US subsidiary would be expected to earn enoughon the project to meet the annual dollar debt service and to repaythe principal in five years.
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Example 2
The two MNC face the following possible borrowing rates:
US capital marketborrowing rate
German capital marketborrowing rate
US MNC 8% 7%
German MNC 9% 6%
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Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cash
flow () with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by theswap)
DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57
Exchange rate implied by international
parity
DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
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Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cashflow (DM) with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by theswap)
DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57
Exchange rate implied by internationalparity
DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
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Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cash
flow () with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by theswap)
1.6 1.2 1.2 1.2 1.2 1.57
Exchange rate implied by international
parity
DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
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Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cashflow () with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by theswap)
1.6 1.2 1.2 1.2 1.2 1.57
Exchange rate implied by international
parity
1.6 1.57 1.54 1.51 1.48 1.46
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
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Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cash
flow () with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by theswap)
1.6 1.2 1.2 1.2 1.2 1.57
Exchange rate implied by internationalparity
1.6 1.57 1.54 1.51 1.48 1.46
US MNC subsidiary in Germany: Cashflow () without the swap, if borrowing inGermany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cashflow () without the swap, if borrowing in
the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow($), without the swap if borrowing in
Germany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
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Analysis:
For the US MNC subsidiary in Germany the borrowing alternativesare the following:
The swap:
Cost of borrowing: locked in at 6%
Borrowing in Germany:
Cost of borrowing locked in at 7%
Borrowing in the US:
Cost of borrowing variable, depends on exchange rate.
If international parity holds it should be 6.025%
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Analysis:
For the German MNC subsidiary in the US the borrowingalternatives are the following:
The swap:Cost of borrowing: locked in at 8%
Borrowing in the US:
Cost of borrowing locked in at 9%
Borrowing in Germany:
Cost of borrowing variable, depends on exchange rate.
If international parity holds it should be 7.97%
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Decision
Clearly, entering the swap reduces some of the uncertainty for bothcompanies.
In the end, the borrowing decision will depend on how both partieswill forecast future exchange rate movements.