Currency swaps

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Currency swaps
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Definition

• A swap is a derivative contract equivalent to a
  bundle of forward contracts
• Swaps are designed to take advantage of the
  Quality Spread Differential - QSD
• QSD arise whenever there is a comparative
  advantage situation

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Exemplification Alpine Ski

• Alpine Ski Inc. is a Swiss manufacturer of
  sporting goods. It needs to borrow 2 m to buy
  supplies and raw material from the United States.
  
• Southern Inc. is a U.S. manufacturer of
  electronic equipment. It needs to borrow SFR 2.8
  m to buy electronic components from Switzerland.
• Southern is relatively unknown in the Swiss
  market.
• The two companies decide to use a dealer to enter
  a foreign currency swap.
• One-year borrowing rates

   Switzerland (SFR) United States ()
Alpine Ski Inc. 7.5 9.875
Southern Inc. 8.5 10
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Note

• Alpine has an absolute advantage at borrowing in
  either USA or Switzerland because it is better
  known
• Alpine has a comparative advantage at borrowing
  at home
• Southern has a comparative advantage at borrowing
  at home

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QSD calculation
   Switzerland (SFR) United States ()
Alpine Ski Inc. 7.5 9.875
Southern Inc. 8.5 10

• QSD 8.5 - 7.5 - 10 - 9.875 0.875
• QSD 87.5 basis points

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Splitting the QSD

• The 87.5 basis points have to be divided among
  Alpine, Southern, and the dealer.
• The dealer is quoting the swap, hence it has more
  power over how the QSD is split

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The onset
2 m at 10
SFR2.8 m at 7.5
SFR2.8 m
2 m
SFR2.8 m
2 m
8
Interest payments
SFR 0.21 m
0.2 m
0.2 m
SFR 0.21 m
0.195 m
SFR 0.224 m
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Repayment of the principal
2 m
SFR2.8 m
2 m
SFR2.8 m
SFR2.8 m
2 m
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Analysis

• Alpine Ski Inc. borrows 2 m and pays 0.195 m in
  interest, that is 9.75.
• Southern Inc. borrows SFR2.8 m and pays SFR0.224
  m in interest, that is 8.

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The dealer

• Pays - (195,000 - 200.000) 5,000
• Receives (SFR224,000 - SFR210,000) SFR14,000
• As long as e lt SFR2.8/  the dealer makes a net
  gain

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Summary
Gets 12.5 basis points
Gets 50 basis points
Gets 25 basis points
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Example 2

• A US MNC desires to finance a capital expenditure
  of its German subsidiary. The project has an
  economic life of five years. The cost of the
  project is 40,000,000. The German subsidiary
  would be expected to earn enough on the project
  to meet the annual dollar debt service and to
  repay the principal in five years.
• Assume a German MNC of equivalent creditworthness
  has a mirror-image financing need. It has a US
  subsidiary in need of 25,000,000 to finance
  capital expenditure with an economic life of five
  years. The US subsidiary would be expected to
  earn enough on the project to meet the annual
  dollar debt service and to repay the principal in
  five years.

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Example 2

• The two MNC face the following possible borrowing
  rates

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Borrowing alternatives
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Borrowing alternatives
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Borrowing alternatives
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Borrowing alternatives
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Borrowing alternatives
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Analysis

• For the US MNC subsidiary in Germany the
  borrowing alternatives are the following
• The swap
• Cost of borrowing locked in at 6
• Borrowing in Germany
• Cost of borrowing locked in at 7
• Borrowing in the US
• Cost of borrowing variable, depends on exchange
  rate.
• If international parity holds it should be
  6.025

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Analysis

• For the German MNC subsidiary in the US the
  borrowing alternatives are the following
• The swap
• Cost of borrowing locked in at 8
• Borrowing in the US
• Cost of borrowing locked in at 9
• Borrowing in Germany
• Cost of borrowing variable, depends on exchange
  rate.
• If international parity holds it should be 7.97

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Decision

• Clearly, entering the swap reduces some of the
  uncertainty for both companies.
• In the end, the borrowing decision will depend on
  how both parties will forecast future exchange
  rate movements.