International Finance Currency Swaps

Interest Rates Each Firm can Borrow at Motivation Firm A wants to borrow £ Firm B wants to borrow $ Each has existing receivables Interest Rates Each Firm can Borrow at Dollars Pounds A 8.0% 11.6% B 10.0% 12.0%

Interest Rates Each Firm can Borrow at Motivation A is more credit-worthy A has absolute advantage in both $ and £ Interest Rates Each Firm can Borrow at Dollars Pounds A 8.0% 11.6% B 10.0% 12.0%

Interest Rates Each Firm can Borrow at Motivation A has comparative advantage in dollars B has comparative advantage in pounds Interest Rates Each Firm can Borrow at Dollars Pounds A 8.0% 11.6% B 10.0% 12.0% A has 2.0% advantage in dollars A has 0.4% advantage in pounds

Interest Rates Each Firm can Borrow at Motivation Swaps work when each firm wants to borrow in currency where other enjoys a comparative advantage Interest Rates Each Firm can Borrow at Dollars Pounds A 8.0% 11.6% B 10.0% 12.0% A: compar adv in $ and wants to borrow pounds B: compar adv in pounds and wants to borrow $

Potential Gain Potential gain from swap Difference between the differences in borrowing rates Potential Gain = 2.0% - 0.4% = 1.6% Dollars Pounds A 8.0% 11.6% B 10.0% 12.0% Difference 2.0% 0.4%

Potential Gain Potential gain from swap Can be divided among firms and intermediary (if used) Potential Gain = 2.0% - 0.4% = 1.6% Dollars Pounds A 8.0% 11.6% B 10.0% 12.0% Difference 2.0% 0.4%

Potential Gain Potential gain from swap Firm A 0.6% Firm B 0.6% Intermediary 0.4% 1.6% = potential gain The distribution of the potential gain among the three parties is negotiated. This is an example.

Mechanics of the Swap Notional principal Amount of money the swapped payments are based on Expressed in both currencies

Mechanics of the Swap Example Firm A will borrow $15 million from its lender Firm B will borrow £10 million from its lender Current spot XR is 1.5 $/£ Each firm is borrowing same amount of money

Mechanics of the Swap Firm A borrows $15 million at 8.0% from its lender Firm B borrows £10 million at 12.0% from its lender Firms A and B give principal to intermediary (usually an investment bank) which passes it through

Mechanics of the Swap Firm A pays interest to intermediary on £ at 11.0% Firm B pays interest to intermediary on $ at 9.4% Intermediary gives A 8.0% on $15 million to pay its lender Intermediary gives B 12.0% on £10 million to pay its lender

Results Firm A borrows £ at 11% instead of 11.6% Firm B borrows $ at 9.4% instead of 10% Intermediary (Investment Bank) Receives 11% on £; 9.4% on $ Pays 12% on £ ; 8% on $ Net to intermediary of 0.4%

Diagram of Currency Swap 11% £ 12% £ 12% £ A Investment Bank B 8% $ 8% $ 9.4% $