HEDGING CURRENCY RISKS: SWAPS

Currency and interest rate swaps A swap agreement between two parties commits each counterparty to exchange an amount of funds, determined by a formula, at regular intervals, until the swap expires In the case of a currency swap, there is an initial exchange of currency and a reverse exchange at maturity

Foreign currency swap A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing. A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency. A “Plain Vanilla” Foreign Currency Swap is when two firms trade fixed-rate interest payments across currencies.

“Plain-Vanilla” foreign currency swap Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country… Dell SFr

“Plain-Vanilla” foreign currency swap Nestle would like to borrow in Dollars to hedge its sales to the U.S... Dell Nestle $ SFr SFr

“Plain-Vanilla” foreign currency swap But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms. Dell Nestle $ SFr SFr

“Plain-Vanilla” foreign currency swap But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them... Dell Nestle Nestle I-Bank $ $ SFr SFr SFr

“Plain-Vanilla” foreign currency swap …and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans... Dell Dell Dell Nestle Nestle Nestle $ Sfr I-Bank I-Bank $ $ $ SFr SFr SFr SFr

“Plain-Vanilla” foreign currency swap …in return for making the payments in the foreign currency that exactly match the other firm’s obligations. Dell Dell Dell Nestle Nestle Nestle Sfr $ $ Sfr I-Bank I-Bank $ $ $ SFr SFr SFr SFr

“Plain-Vanilla” foreign currency swap In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms. Dell Dell Dell Nestle Nestle Nestle Sfr $ $ Sfr I-Bank $ $ $ SFr SFr

Comparative borrowing advantage Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant. One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty. In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell. Nonetheless, a swap may be mutually advantageous.

Origins and underpinnings of the swap market In the early 1980s, the currency swap evolved as a way to simplify and speed the exchange of currency cash flows between counterparties, and quickly gained popularity. the use of a swap lowers the transaction costs. as a new financial product, it was also not covered by any accounting disclosure or security registration requirements.

Accidents in risk management Corporate Sector Organization Year Losses Contracts Procter & Gamble 1994 $102 million Interest rate swap (U.S.) Gibson Greetings 1994 $20 million Interest rate swap Showa Shell 1993 $1.54 billion Foreign exchange (Japan) Metallgesellschaft 1993 $1.3 billion Oil futures (Germany) Allied Lyons 1991 $265 million Foreign exchange (U.K.) options

Accidents in risk management Public Agencies Organization Year Losses Contracts State of Wisconsin 1995 $95 million Interest rate swaps Investment Board (U.S.) Orange County 1994 $1.7 billion U.S. government (U.S.) securities and interest rate derivatives British Councils 1986 $900 million Interest rate swaps (U.K.) -1988

The basic cash flows of a currency swap Firms A and B can each issue a 7-year bond in either the US$ or SFr market. Firm A enjoys an absolute advantage in both credit markets. 11.5% 10% 5% 6% Firm A Firm B US$ finance SFr

The basic cash flows of a currency swap Firm A has a comparative advantage in borrowing US$, while firm B has a comparative advantage in borrowing SFr. Difference (A-B) -1.5% -1.0% - 0.5% 11.5% 10% 5% 6% Firm A Firm B US$ finance SFr By borrowing in their comparative advantage currencies and then swapping, lower cost financing is possible.

The basic cash flows of a currency swap $ at t 0 SFr at t 0 10.75% (US$) [t 1 - t 7] 5.5% (SFr) [t 1 - t 7] A Borrows $ at 10% for 7 years B Borrows SFr at 6% $ at t 7 SFr at t 7 Together, A and B save 0.5%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.

Other types of swaps “Plain Vanilla” Interest (Fixed-for-Floating) Rate Swaps One counterparty exchanges the interest payments of a floating-rate debt obligations for the fixed-rate interest payments of the other counterparty. Currency-Interest Rate Swaps: One counterparty exchanges the floating-rate debt service obligations of a bond denominated in one currency for the fixed-rate debt service obligations denominated in the other currency.

Currency swaps What risks exist in entering into a swap and maintaining it? interest rate risk exchange rate risk credit risk

Example In 1998 several Korean banks refused to pay the American banks hundreds of millions of dollars owed under deals involving currency swaps Swap contracts were signed on the assumption that the underlying currency would remain stable. SK Securities sued J.P. Morgan J.P. Morgan sued SK Securities SK Securities claimed J.P. Morgan missinformed its customers When the baht started to fall, J.P. Morgan told its customers that the currency would soon stabilize and insisted his client has ample evidence to back its claims

The basic cash flows of a IR swap Firms A and B can each issue a 7-year US$ denominated bond in either fixed-rate or floating-rate terms. Firm A enjoys an absolute advantage in both credit markets? 10.5% 9% LIBOR +0.0% +0.5% Firm A Firm B Fixed- rate finance Floating-

The basic cash flows of a IR swap Firm A has a comparative advantage in the fixed-rate bond market, while firm B has a comparative advantage in the floating-rate bond market. Difference (A-B) -1.5% - 0.5% - 1.0% 10.5% 9% LIBOR +0.0% +0.5% Firm A Firm B Fixed- rate finance Floating- By borrowing in their comparative advantage markets and then swapping, lower cost financing is possible.

The basic cash flows of a IR swap 9.75% LIBOR + .25 Interest payments to each other in years t 1 to t 7. A B Borrows at 9.0% fixed for 7 years LIBOR + 0.50% floating Together, A and B save 1%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.

The pricing of swaps The swap price should be based on the net present value of the expected future cash flows In addition, numerous parity or arbitrage linkages among swap contracts aid in the determination of swap prices

The pricing of swaps Currency X Currency Y Fixed Rate Asset or Liability Floating Rate Interest Rate Base Currency of Denomination Two currencies, X and Y, have both fixed-rate and floating-rate segments. Fixed-Fixed Currency Swap A Interest Rate Swap B C Cross Currency Interest Rate Swap Interest Rate Swap Floating-Floating Currency Swap D For example, with an interest rate swap in currency X (AB) and a fixed-fixed currency swap (AC), we can construct a cross currency interest rate swap (BC).