Currency Swap

Currency Swap: Definition Exchange of a liability in one currency for a liability in another currency. Nature: –US corporation with operations in France can obtain comparatively better terms by borrowing dollars, but prefers a loan in FF. –French corporation with operations in the US can obtain comparatively better terms by borrowing FF, but prefers a loan in dollars. –The two companies could go to a swap bank who could arrange for a loan swap.

Example German company can issue a 5-year, DM 62.5 M bond paying 7.5% interest to finance the construction of its assembly plant in the US. The company, though, would prefer to borrow an equivalent amount in dollars. Assuming the current spot exchange rate is Eo = $0.40/DM, the equivalent dollar amount is $25M.

Example An American company can issue a 5-year, $25 M at 10% interest to finance the development of a hotel in Munich. The company, though, would prefer to borrow an equivalent amount in DM. Assuming the current spot exchange rate is Eo = $0.40/DM, the equivalent DM amount is DM 62.5M.

Example: Agreement 1 Suppose the two companies go to a swap bank who sets up the following arrangements. Agreement 1: –German company will issue a 5-year DM 62.5M bond at 7.5%, then pay DM 62.5M to the swap bank (SB) who will pass it onto the American company to finance its Munich hotel development. –American company will issue a 5-year $25M bond at 10%, then pay $25M to SB who will pass it onto the German company to finance the construction of its US assembly plant.

Agreement 1

Example: Agreement 2 Agreement 2: Interest Payments for each of the next five years: –German company (with its US asset) will pay $2.5M in interest (10% interest on $25 M) to the swap bank who will pass it onto the American company to pay its creditors. –American company (with its German asset) will pay DM M in interest (7.5% interest on DM 62.5M) to the SB who will pass it onto the German company to pay its creditors.

Agreement 2

Example: Agreement 3 Agreement 3: Principal Payments at maturity: –German company will pay $25M to the swap bank who will pass it onto the American company to pay its creditors’ principal. –American company will pay DM 62.5M to the SB who will pass it onto the German company to pay its creditors’ principal.

Agreement 3

Currency Swap and Currency Forward Contract For the interest payments, the German company agrees to pay $2.5M for DM M each year for five years. This is equivalent to a series (strip) of long currency forward contracts at a forward rate of $0.53/DM:

Currency Swap and Currency Forward Contract For the principal payment, the German company agrees to pay $25M for DM 62.5 M at the end of five years. This is equivalent to a long currency forward contract at a forward rate of $0.40/DM: Note: The American position is the equivalent to a short forward position.

Comparative Advantage The above swap represents a swap of equivalent loans. Most swaps originate from two companies having comparative advantages in lending in their particular country.

Comparative Advantage: Example Suppose the American and German company have access to both German and American lending markets. Suppose the American company is more creditworthy and can obtain lower rates than the German company in both the US and German market.

Comparative Advantage: Example The American company has a comparative advantage in the US market: it pays 1% less than the German company in the US market, compared to only.25% less in the German market. The German company has a comparative advantage in the German market: it pays.25% more than the American company in the German market, compared to 1% more in the US market.

Comparative Advantage: Example When a comparative advantage exist, a swap bank is in a position to benefit one or both parties. Swap Agreement: –American company borrows $25M at 10% interest and swaps it for DM 62.5M loan at 7% interest -- a.25% better loan than it can get in the German market. –German company borrows DM 62.5M at 7.5% and swaps it for $25M loan at 10.5% -- a.5% better loan than it can get in the US market.

Swap Interest Payments

Comparative Advantage: Swap Bank’s Position Swap bank: For each of the next five years: Receives $2.625M and pays $2.5M, for a net dollar gain of $0.125M. Receives DM 4.375M and pays DM 4.625M for a net DM loss of DM M. This is the equivalent to a series of long forward contracts: agree to buy DM M for $0.125M. The implied swap rate is $0.40/DM:

Comparative Advantage: Swap Bank’s Hedge The swap bank could hedge its position if it could find a forward rate at $0.40/DM or less or form a synthetic position using the money market. Suppose Ef = $0.39/DM. The swap bank could go long, agreeing to buy DM M for $0.122M ((DM M)($0.39/DM) = $0.122M). The swap position and long forward contract would leave the swap bank with a profit of $3000. Profit = $0.125M - $0.122M = $0.003M