1. International Finance
Currency Swaps

2. 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%

3. 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%

4. 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

5. 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 $

6. 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%

7. 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%

8. 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.

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

10. 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

11. 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

12. 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

13. 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%

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