OUTRIGHT FORWARDS AND SWAPS

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OUTRIGHT FORWARDS AND SWAPS

• An outright forward contract consists simply of
  an agreement to exchange currencies at an agreed
  price at a future date
• In general, a swap represents an agreement to
  exchange cash flows between two parties, called
  counterparties

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• A plain vanilla currency swap (or
  foreign-exchange swap) consists of the
  simultaneous buying and selling of the same
  amount of the same currency with the same
  counterparty, where the two transactions mature
  at different dates and are traded at different
  exchange rates
• Most plain vanilla currency swaps involve a spot
  transaction and a forward transaction in the
  opposite direction

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• E.g. Suppose Bank A contacts Bank B for a USD/CHF
  10,000,000 swap in six months
• Bank B quotes a CHF/USD spot 1.5060-65 and a
  6-month forward spread 78-82
• Bank A takes the offer at 82 (suppose on January
  31) and Bank B agrees to
• ? buy 10m spot against Swiss francs from Bank A
  at SFr1.5060/ on February 2

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• ? sell 10m in forward to Bank A at SFr1.5142/
  on August 2
• Bank B can make a profit from this swap by
  entering into a swap contract with Bank C at a
  forward spread lower than 82 (premium)
• Suppose that Bank C quotes the same spot rates,
  but a 75-80 6-month forward spread

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• Bank B agrees to
• ? sell 10m spot against SFr to Bank C at
  SFr1.5060/ on February 2
• ? buy 10m forward from Bank C at SFr1.514/ on
  August 2
• Bank B makes a profit of SFr2,000
• The following table summarizes transactions and
  profits for Bank B

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TYPES OF SWAPS

• A swap-in agreement involves buying a currency
  spot and selling it forward
• A swap-out agreement involves selling a currency
  spot and buying it forward

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• A forward-forward swap involves two forward
  transactions, e.g. buy a currency forward in one
  month and sell it forward in 3 months
• A currency swap is an agreement to exchange a
  principal amount of two different currencies and
  give back the principal after a specified period
  of time

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USES OF SWAPS

• Swaps are extensively used among banks
• For some dates and currencies, a bank will be
  long in FX, which means that it has agreed to
  purchase more of the foreign currency than it has
  agreed to sell
• For other dates and currencies, a bank will be
  short in FX, meaning that it has agreed to sell
  more of the foreign currency than it has agreed
  to buy

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• E.g. Bank A is long on spot and short on 30-day
  forward
• Bank B is short on spot and long on forward
• Banks benefit from exchanging their currency
  surpluses
• Bank A sells spot and buys forward Bank B
  will do the reverse

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SWAP POINTS AND FORWARD-RATE QUOTATION

• In the interbank FX market, forward rates are
  quoted in terms of spot rates and swap points for
  various forward maturities
• E.g. 6-month forward C is quoted as 1.3365-70
  with swap points 23-27
• Swap points may be added or subtracted from bid
  and ask spot rates

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• When the numbers are ascending, swap points are
  added to spot bid and ask rates
• E.g. the 6-month forward bid rate for the U.S.
  in terms of Canadian dollars is
• Can 1.3365/ Can 0.0023/ Can 1.3388/
• The rule shows that the bid-ask spread is larger
  in the forward compared to the spot market

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• Explanation forward market is thinner than spot
  market (smaller trading volume)
• Banks face uncertainty about price of offsetting
  forward contracts after quoting their rates

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CURRENCY SWAPS

• Currency swaps, also known as capital market
  swaps, are common among corporations
• Corporations use their comparative advantage in
  terms of borrowing costs in different currencies
• Corporations can lower their borrowing costs by
  borrowing in the comparative advantage currency
  and swapping

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• For example (borrowing in domestic currency only)
• ? Corporation A can borrow in Mexican pesos, but
  needs yen
• ? Corporation B can borrow in yen, but needs
  Mexican pesos
• ? The two companies can benefit through a
  currency swap

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• Another example (different borrowing costs)
• ? Corporation A can borrow in at 10 and in
  DKr at 15
• ? Corporation B can borrow in DKr at 13 and in
  at 16
• ? Even though both A and B can borrow in both
  currencies, they can benefit from currency swap

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EXAMPLE OF CURRENCY SWAP

• Suppose that two companies, a Swiss firm, called
  Novartis, and an American firm, called Nike, can
  borrow as follows
• ? Novartis could issue corporate bonds in SFr
  with a coupon of 7.5
• ? Novartis could issue corporate bonds in with
  a coupon of 9.875

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• Novartis faces different borrowing costs due to
  different credit ratings in the two markets
• Novartis needs (lets say 2m) it can issue
  SFr bonds for SFr2.8m
• Assume exchange rate is SFr1.4/

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• Nike can borrow as follows
• ? Issue corporate bonds in with a coupon of
  10
• ? Issue corporate bonds in SFr with a coupon of
  8.5
• ? Nike needs SFr (lets say SFr2.8m) it can
  issue bonds for 2m

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• Two firms can benefit from a currency swap
• They face different borrowing costs due to
  different credit ratings
• We can examine which company has a comparative
  borrowing advantage in, lets say,

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• Conclusion Novartis has a comparative borrowing
  advantage in SFr
• Novartis will issue 3-year bonds with face value
  SFr2.8m and coupon 7.5
• Nike will issue 3-year bonds with face value 2m
  and coupon 10

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• The currency swap will be completed through a
  swap dealer
• The swap dealer acts as an intermediary and will
  charge a fee
• The dealer will collect cash flows from Novartis
  and pass them to Nike and the other way round

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• Suppose that the dealer arranges for Novartis to
  pay 9.75 annual rate on the 2m and Nike to pay
  8 on the SFr2.8m
• We can examine the initial cash flows, the annual
  cash flows, and the cash flows at maturity in
  this swap
• In the end, each party involved in the swap
  benefits, including the swap dealer

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INITIAL SWAP CASH FLOWS
Swiss Bondholders
U.S. Bondholders
SFr2.8m
2m
SFr2.8m
SFr2.8m
Novartis
Swap Dealer
NIKE
2m
2m
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ANNUAL CASH FLOWS
Swiss Bondholders
U.S. Bondholders
SFr0.21m
0.2m
SFr.224m
SFr0.21m
Novartis
Swap Dealer
NIKE
0.195m
0.2m
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CASH FLOWS AT MATURITY
Swiss Bondholders
U.S. Bondholders
SFr3.01m
2.2m
SFr3.024m
SFr3.01m
Novartis
Swap Dealer
NIKE
2.195m
2.2m
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GAINS FOR PARTIES INVOLVED IN CURRENCY SWAP

• Novartis converted a SF2.8 million bond issue at
  7.5 into a 2 million bond issue at 9.75
• Novartis saved 1/8 of a percentage point over
  what it would cost if it borrowed directly in the
  U.S. market ( 9 and 7/8 percent)
• Nike converted a 2 million bond issue at 10
  into a SF2.8 million bond issue at 8

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• Nike saved 1/2 of a percentage point of interest
  over what it would pay by borrowing directly in
  the Swiss market
• The swap dealer profits from the difference in
  interest rates
• Overall, the dealer gains 1/4 percent in interest
• If the dealer operates in , then the dealer must
  also hedge the exposure in SFr

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EXAMPLE OF CURRENCY SWAP

• Suppose two companies, A and B, enter into a
  direct five-year currency swap on February 5,
  2001
• Suppose that A pays a fixed annual rate of 11 in
  and receives a fixed 8 annual rate in
• The principal amounts are 15m and 10m
• Show the cash flows in this swap agreement

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INITIAL CASH FLOWS
15million
A
B
10million
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ANNUAL CASH FLOWS
1.10million
A
B
1.20million
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CASH FLOWS AT MATURITY
11.10million
A
B
16.20million