Currency Swaps

1

• Currency Swaps
• (Shapiro Chapter 9)

2
Definitions

• In a swap, two counterparties agree to a
  contractual arrangement wherein they agree to
  exchange cash flows at periodic intervals.
• There are two types of interest rate swaps
• Single currency interest rate swap
• Plain vanilla fixed-for-floating swaps are
  often just called interest rate swaps
• The periodic cash flows are in the same currency
  
• Cross-Currency interest rate swap
• This is often called a currency swap fixed for
  fixed rate debt service in two (or more)
  currencies
• The periodic cash flows are NOT in the same
  currency

3
Size of the Swap Market

• In 2001 the notional principal of
• Interest rate swaps was 58,897,000,000.
• Currency swaps was 3,942,000,000
• The most popular currencies are
• U.S. dollar
• Japanese yen
• Euro
• Swiss franc
• British pound sterling

4
The Swap Bank

• A swap bank is a generic term to describe a
  financial institution that facilitates swaps
  between counterparties.
• The swap bank can serve as either a broker or a
  dealer.
• As a broker, the swap bank matches counterparties
  but does not assume any of the risks of the swap.
• As a dealer, the swap bank stands ready to accept
  either side of a currency swap, and then later
  lay off their risk, or match it with a
  counterparty.

5
Interest Rate Swap

• An Example
• Consider this example of a plain vanilla
  interest rate swap.
• Bank A is a AAA-rated international bank located
  in the U.K. and wishes to raise 10,000,000 to
  finance floating-rate Eurodollar loans.
• Bank A is considering issuing 5-year fixed-rate
  Eurodollar bonds at 10 percent.
• It would make more sense for the bank to issue
  floating-rate notes at LIBOR to finance
  floating-rate Eurodollar loans.

6
An Example of an Interest Rate Swap

• Firm B is a BBB-rated U.S. company. It needs
  10,000,000 to finance an investment with a
  five-year economic life.
• Firm B is considering issuing 5-year fixed-rate
  Eurodollar bonds at 11.75 percent.
• Alternatively, firm B can raise the money by
  issuing 5-year floating-rate notes at LIBOR ½
  percent.
• Firm B would prefer to borrow at a fixed rate.

7
An Example of an Interest Rate Swap

• The borrowing opportunities of the two firms are

8
An Example of an Interest Rate Swap
The swap bank makes this offer to Bank A You pay
LIBOR 1/8 per year on 10 million for 5 years
and we will pay you 10 3/8 on 10 million for 5
years
Swap Bank
Bank A
9
An Example of an Interest Rate Swap
½ of 10,000,000 50,000. Thats quite a cost
savings per year for 5 years.
Heres whats in it for Bank A They can borrow
externally at 10 fixed and have a net borrowing
position of -10 3/8 10 (LIBOR 1/8) LIBOR
½ which is ½ better than they can borrow
floating without a swap.
Swap Bank
Bank A
10
An Example of an Interest Rate Swap
The swap bank makes this offer to company B You
pay us 10½ per year on 10 million for 5 years
and we will pay you LIBOR ¼ per year on 10
million for 5 years.
Swap Bank
Company B
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An Example of an Interest Rate Swap
Heres whats in it for B
½ of 10,000,000 50,000 thats quite a cost
savings per year for 5 years.
Swap Bank
They can borrow externally at LIBOR ½ and
have a net borrowing position of 10½ (LIBOR
½ ) - (LIBOR - ¼ ) 11.25 which is ½ better
than they can borrow floating.
Company B
LIBOR ½
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An Example of an Interest Rate Swap
¼ of 10 million 25,000 per year for 5 years.
The swap bank makes money too.
Swap Bank
Company B
Bank A
LIBOR 1/8 LIBOR ¼ 1/8 10 ½ - 10 3/8
1/8 ¼
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An Example of an Interest Rate Swap
The swap bank makes ¼
Swap Bank
Company B
Bank A
B saves ½
A saves ½
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Currency Swap

• An Example
• Suppose a U.S. MNC wants to finance a 10,000,000
  expansion of a British plant.
• They could borrow dollars in the U.S. where they
  are well known and exchange for dollars for
  pounds.
• This will give them exchange rate risk financing
  a sterling project with dollars.
• They could borrow pounds in the international
  bond market, but pay a premium since they are not
  as well known abroad.

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An Example of a Currency Swap

• If they can find a British MNC with a
  mirror-image financing need they may both benefit
  from a swap.
• If the spot exchange rate is S0(/) 1.60/,
  the U.S. firm needs to find a British firm
  wanting to finance dollar borrowing in the amount
  of 16,000,000.

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An Example of a Currency Swap

• Consider two firms A and B firm A is a
  U.S.based multinational and firm B is a
  U.K.based multinational.
• Both firms wish to finance a project in each
  others country of the same size. Their borrowing
  opportunities are given in the table below.

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An Example of a Currency Swap
Swap Bank
Firm B
Firm A
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An Example of a Currency Swap
Swap Bank
As net position is to borrow at 11
9.4
Firm B
Firm A
8
12
A saves .6
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An Example of a Currency Swap
Bs net position is to borrow at 9.4
Swap Bank
9.4
Firm B
Firm A
8
12
B saves .6
20
An Example of a Currency Swap
1.4 of 16 million financed with 1 of 10
million per year for 5 years.
The swap bank makes money too
Swap Bank
9.4
Firm B
Firm A
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At S0(/) 1.60/, that is a gain of 64,000
per year for 5 years.
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The swap bank faces exchange rate risk, but maybe
they can lay it off (in another swap).
21
An Example of a Currency Swap
After the swap initiation, A sends the 16m to B
in exchange for 10m. Firm A agrees to pay the
bank 0.11x10m. 1.1m every year. Firm B agrees
to pay the bank 0.094x16m. 1.504m every
year. The bank agrees to pay firm B 0.12x10m.
1.2m every year and to pay firm A 0.08x16m.
1.28m. At S0(/) 1.60/, that is a gain of
64,000 per year for 5 years. At the end of year
5, the principal values are re-exchanged. Firm A
sends 10m to firm B in exchange for 16m.
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The QSD

• The Quality Spread Differential (QSD) represents
  the potential gains from the swap that can be
  shared between the counterparties and the swap
  bank.
• There is no reason to presume that the gains will
  be shared equally.
• In the above example, company B is less
  credit-worthy than bank A, so they probably would
  have gotten less of the QSD, in order to
  compensate the swap bank for the default risk.

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Comparative Advantage as the Basis for Swaps

• A is the more credit-worthy of the two firms.

A pays 2 less to borrow in dollars than B
A pays .4 less to borrow in pounds than B
A has a comparative advantage in borrowing in
dollars. B has a comparative advantage in
borrowing in pounds.
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Comparative Advantage as the Basis for Swaps

• B has a comparative advantage in borrowing in .

B pays 2 more to borrow in dollars than A
B pays only .4 more to borrow in pounds than A
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Comparative Advantage as the Basis for Swaps

• A has a comparative advantage in borrowing in
  dollars.
• B has a comparative advantage in borrowing in
  pounds.
• If they borrow according to their comparative
  advantage and then swap, there will be gains for
  both parties.

26
Swap Market Quotations

• Swap banks will tailor the terms of interest rate
  and currency swaps to customers needs
• They also make a market in plain vanilla swaps
  and provide quotes for these. Since the swap
  banks are dealers for these swaps, there is a
  bid-ask spread.
• For example, 6.60 6.85 means the swap bank will
  pay fixed-rate Euro payments at 6.60 against
  receiving dollar LIBOR or it will receive
  fixed-rate Euro payments at 6.85 against
  receiving dollar LIBOR.

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An Example
Consider two firms A and B. Firm A is a US-based
firm that would like to borrow funds to finance a
project in France. Firm B is a French firm that
would like to borrow funds in the US. Firm A can
borrow at 4 in the US and 5 in France, while
Firm B can borrow at 4 in France and 5 in the
US. Assume that the current spot rate is
1/Euro. Also assume that the principal value of
the transaction is 20 million. The contract
matures in 3 years. There is no swap bank
intermediary. Outline the cash flows that will
result from this swap.
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An Example

• Answer
• Initial borrowings
• Firm A borrows 20 million at 4 in the US for 3
  years
• Firm B borrows Euro 20 million at 4 in France
  for 3 years
• Cash flows
• Firm A sends 20 million to firm B in exchange
  for Euro 20 million
• Firm A agrees to pay firm B Euro fixed rate 4
  for 3 years. Each
• annual payment will equal Euro 800,000
• Firm B agrees to pay firm A US dollar fixed rate
  4 for 3 years.
• Each annual payment will equal 800,000
• At the end of year 3, the principal values are
  re-exchanged.
• Firm A sends Euro 20 million to firm B in
  exchange for 20 million