Currency swaps Definition A swap is a derivative contract equivalent to a bundle of forward...
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Transcript of Currency swaps Definition A swap is a derivative contract equivalent to a bundle of forward...
Currency swapsCurrency swaps
DefinitionDefinition
A swap is a derivative contract equivalent to a bundle of forward contracts
Swaps are designed to take advantage of the Quality Spread Differential - QSD
QSD arise whenever there is a comparative advantage situation
Exemplification: Alpine Ski
Alpine Ski Inc. is a Swiss manufacturer of sporting goods. It needs to borrow $2 m to buy supplies and raw material from the United States.
Southern Inc. is a U.S. manufacturer of electronic equipment. It needs to borrow SFR 2.8 m to buy electronic components from Switzerland.
Southern is relatively unknown in the Swiss market.
The two companies decide to use a dealer to enter a foreign currency swap.
One-year borrowing rates:
Switzerland (SFR) United States ($)
Alpine Ski Inc. 7.5% 9.875%
Southern Inc. 8.5% 10%
Note
Alpine has an absolute advantage at borrowing in either USA or Switzerland because it is better known
Alpine has a comparative advantage at borrowing at home
Southern has a comparative advantage at borrowing at home
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%
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 more power over how the QSD is split
The onset
Swiss creditors US creditors
Dealer
AlpineSouthern
SFR2.8 m
at 7.5%
SFR2.8 m
SFR2.8 m
$2 m at 10%
$2 m
$2 m
Interest payments
Swiss creditors 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
Repayment of the principal
Swiss creditors US creditors
Dealer
AlpineSouthern
SFR2.8 m
SFR2.8 m
SFR2.8 m
$2 m
$2 m
$2 m
Analysis
Alpine Ski Inc. borrows $2 m and pays $0.195 m in interest, that is 9.75%.
Southern Inc. borrows SFR2.8 m and pays SFR0.224 m in interest, that is 8%.
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
Summary
Alpine
Southern
Dealer
Gets 12.5 basis points
Gets 50 basis points
Gets 25 basis points
Example 2Example 2
A US MNC desires to finance a capital expenditure of its German subsidiary. The project has an economic life of five years. The cost of the project is €40,000,000. The German subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.
Assume a German MNC of equivalent creditworthness has a mirror-image financing need. It has a US subsidiary in need of $ 25,000,000 to finance capital expenditure with an economic life of five years. The US subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.
Example 2Example 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%
Borrowing alternativesBorrowing alternatives
today 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 ($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by the swap)
DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57
Exchange rate implied by international parity
DM 1.6 DM 1.57 DM 1.54
DM 1.51 DM 1.48 DM 1.46
US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow ($) without the swap, if borrowing in the US
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow ($), without the swap if borrowing in Germany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
Borrowing alternativesBorrowing alternatives
today Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cashflow (DM) with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow($) 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
Borrowing alternativesBorrowing alternatives
today 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 ($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by the swap)
€ 1.6 € 1.2 € 1.2 € 1.2 €1.2 € 1.57
Exchange rate implied by international parity
DM 1.6 DM 1.57 DM 1.54
DM 1.51 DM 1.48 DM 1.46
US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow ($) without the swap, if borrowing in the US
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow ($), without the swap if borrowing in Germany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
Borrowing alternativesBorrowing alternatives
today Year1 Year 2 Year 3 Year 4 Year 5
US MNC subsidiary in Germany: Cash flow (€) with swap
40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m
German MNC subsidiary in US: Cash flow ($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by the swap)
€ 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: Cash flow (DM) without the swap, if borrowing in Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cash flow (DM) 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 ($) without the swap, if borrowing in the US
25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m
German MNC subsidiary in US: Cash flow ($), without the swap if borrowing in Germany
25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m
Borrowing alternativesBorrowing alternatives
today 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 ($) with swap
25 m -2 m -2 m -2 m -2 m -27 m
Contractual exchange rate (implied by the swap)
€ 1.6 € 1.2 € 1.2 € 1.2 € 1.2 € 1.57
Exchange rate implied by international parity
€ 1.6 € 1.57 € 1.54
€ 1.51 € 1.48 € 1.46
US MNC subsidiary in Germany: Cash flow (€) without the swap, if borrowing in Germany
40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m
US MNC subsidiary in Germany: Cash flow (€) without the swap, if borrowing in the US
40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m
German MNC subsidiary in US: Cash flow ($) without the swap, if borrowing in the US
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
Analysis:Analysis:
For the US MNC subsidiary in Germany the borrowing alternatives are 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%
Analysis:Analysis:
For the German MNC subsidiary in the US the borrowing alternatives 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%
DecisionDecision
Clearly, entering the swap reduces some of the uncertainty for both companies.
In the end, the borrowing decision will depend on how both parties will forecast future exchange rate movements.