Currency Swaps

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Overview of the Lecture

1. Definitions

2. Motivation

3. A simple example

4. A real world example

1. Definitions

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Presentation

• There are two main kinds of swaps (currency and interest rate) but many different variations exist.

• As a whole, the swaps market is by far the largest financial derivative market in the world.

• Currency swap is a long-term financing/hedging technique. It helps manage both interest and exchange rate risk.

• It can be viewed as a series of forward contracts.

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Currency swap

• A currency swap is an agreement to exchange principal and fixed interest in one currency for principal and fixed interest in another currency.

• The initial value of the contract is usual chosen to be zero.

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Properties• A currency swap gives the parties to the

contract the right of offset, that is the right to offset any nonpayment of principal or interest with a comparative nonpayment.

• A currency swap is not a loan and therefore does not change the liability structure of the parties’ balance sheets.

• There is an exchange of principal (unlike for interest rate swaps).

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A bit of history

• Before 1981 companies were involved in back-to-back loans where they agreed to borrow in their domestic currency and lend to each other these currencies.

• The long-term currency swap transactions started in August, 1981.

• The World Bank issued $290mln in bonds and used the dollar proceeds in currency swaps with IBM for German marks and Swiss francs.

2. Motivation: Cross-currency comparative

advantage

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9Usual conditions for a currency swap

• In general, currency swap assumes that one counterparty borrows under specific terms and conditions in one currency, while the other counterparty borrows under different terms and conditions in a second currency.

• The two counterparties exchange the net receipts from their respective issues and agree to service each other’s debt.

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Example 1

Suppose two firms, A and B, can borrow at the fixed rates of interest as follows:

$ €

Firm A 10.0% 12.2%

Firm B 12.8% 11.0%

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11An absolute borrowing advantage

• Observe:– Firm A can pay 2.8% less than firm B on the debt

denominated in U.S. dollars. – Firm A must pay 1.2% more than firm B on the debt

denominated in euros.

• Therefore:– Firm A has an absolute advantage in borrowing in the

U.S. dollar market.– Firm B has an absolute advantage in borrowing in the

euro market.

• The minimum rate in each market could be reached.

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Example 2

Suppose two firms, A and B, can borrow at the fixed rates of interest as follows:

$ €Firm A 10.0%12.2%

Firm B 11.0%12.8%

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13A comparative borrowing advantage

• Observe:– Firm A can pay full 1.0% less than firm B on the debt

denominated in U.S. dollars. – Firm A can pay only 0.6% less than firm B on the debt

denominated in euros.

• Therefore:– Firm A has a comparative advantage in borrowing in

the U.S. dollar market.– Firm B has a comparative advantage in borrowing in

the euro market.

• The total cost of borrowing could be decreased.

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How does it happen?

• Firm A may be an American company and/or known better to American investors and financial institutions.

• Firm B may be a German company and/or known better to German or European investors and financial institutions.

3. A Simple Example

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16Firms need financing in a foreign currency

• Suppose firm A wants to borrow €30M to finance its new production line in Germany.

• Suppose firm B wants to borrow $20M to raise capital for its subsidiary in the U.S.

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Scenario 1: direct borrowing

• Firm A borrows € at 12.2%.

• Firm B borrows $ at 11.0%.

• The combined cost of borrowing for two firms is 12.2+11.0 = 23.2%.

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18Scenario 1: initial cash flow diagram

German Bank

€30M12.2%

U.S. Bank$20M11.0%

Firm A Firm B

GermanBranch

U.S. Subsidiary

€30M

€30M

$20M

$20M

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19Scenario 2: indirect borrowing (with a currency

swap)• Firm A borrows $ at 10.0%.• Firm B borrows € at 12.8%.• Firms swap currencies at the beginning and at

the maturity of the contract.• Firms pay each other’s interest payments.

– Firm A pays firm B 12.8% on €30M, €3.84M.– Firm B pays firm A 10.0% on $20M, $2M.

• Firm A compensates firm B for borrowing € at 12.8% rather than $ at 11.0%.

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20Scenario 2: initial cash flow diagram

U.S. Bank

$20M10.0%

German Bank€30M12.8%

Firm A Firm B

GermanBranch

U.S.Subsidiary

€30M

€30M

$20M

$20M

€30M $20M

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21Scenario 2: interest flow diagram

U.S. Bank

$20M10.0%

German Bank€30M12.8%

Firm A Firm B

GermanBranch

U.S.Subsidiary

€3.84M

€3.84M

$2M

$2M

€3.84M $2M

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22Scenario 3: final cash flow diagram

U.S. Bank

$20M10.0%

German Bank€30M12.8%

Firm A Firm B

GermanBranch

U.S.Subsidiary

€30M

€30M

$20M

$20M

€30M $20M

4. A Real World Example:Kodak’s Zero-Coupon Australian Dollar Swapthrough Merrill Lynch

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Kodak’s financial needs

• It needs at least $75M for 5 years.

• In the U.S. market it can borrow at 7.5% (50 basis points above U.S. Treasuries).

• Outside the U.S. it can borrow at 7.35% (35 basis points above U.S. Treasuries).

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25Merrill Lynch’s market analysis

• Investor interest in non-dollar issues is much stronger in Europe than in the U.S.

• Kodak should issue a Eurobond debt dominated in a currency different from the U.S. dollar.

• Australian zero-coupon issue is selling very well in Europe.

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The beginning

• Kodak issues a A$200M zero-coupon, 5-year Eurobond.

• Net proceeds to Kodak were A$106M or 53% of A$200M.

• What is the Kodak’s cost of the Eurobond issue?

5$Ar1

A$200A$106

13.5%r$A

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27What can Kodak do? - alternative 1

• Kodak can obtain its desired $75M by converting A$106M at the $/A$ = 0.7059.

• Kodak is exposed to fluctuations in the value of the Australian dollar against the U.S. dollar.

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28What can Kodak do? - alternative 2

• Kodak enters into a 5-year swap contract with Merrill Lynch.

• At the beginning of the contract, Kodak swaps A$106M for $75M.

• Over the life of the contract, Kodak pays 7.35% of $75M ($2,756,250 semiannually) to Merrill Lynch.

• At the maturity of the contract, Kodak swaps $75M back for A$106M.

• Kodak’s currency risk exposure is eliminated.

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The position of Merrill Lynch

• The currency risk is fully transferred from Kodak to Merrill Lynch.

• Is Merrill Lynch happy with that? No.

• What can Merrill Lynch do? It can enter into a currency swap with a party that is willing to pay $ in exchange for A$.

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Merrill Lynch’s currency swap conditions

• Merrill Lynch enters into a swap contract with an Australian Bank agreeing to make semiannual payments of LIBOR less 40 basis points.

• The Australian bank cannot swap A$200M. It can only swap A$130M and pay Merrill Lunch 13.39% semiannually.

• Merrill Lynch still has currency exposure because it is left with A$70M (A$200M-A$130M).

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Merrill Lynch’s next step• Merrill Lynch exchanges the remaining A$38M

(A$106M-A$68M) for $27M in the spot market.

• Merrill Lynch enters into a forward contract with the Australian bank to exchange $37M for A$70M in five years at the rate $/A$ = 0.5286.

• Now Merrill Lynch is no longer exposed to currency risk.

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32Merrill Lynch’s last risk exposure

• Merrill Lunch is exposed to interest rate risk.

• Where does this risk come from? From Merrill Lynch’s floating rate obligations on the A$68M for $48M swap with the Australian bank.

• What can Merrill Lynch do? It can enter into an interest rate swap with a party that is willing to pay a floating rate and receive a fixed rate.

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Conclusions• Currency swaps provide real benefits to both

parties.

• Currency swaps are beneficial when there exist cross-country barriers to full arbitrage.

• Currency swaps are useful when long-term capital is needed and the forward foreign exchange markets are not well developed.