Currency Swap

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Currency Swap
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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.

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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.

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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.

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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.

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Agreement 1
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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 4.6875M in interest (7.5 interest on DM
  62.5M) to the SB who will pass it onto the German
  company to pay its creditors.

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Agreement 2
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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.

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Agreement 3
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Currency Swap and Currency Forward Contract

• For the interest payments, the German company
  agrees to pay 2.5M for DM 4.6875 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

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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.

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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.

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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.

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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.

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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.

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Swap Interest Payments
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Comparative Advantage Swap Banks 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 0.3125M.
• This is the equivalent to a series of long
  forward contracts agree to buy DM 0.3125M for
  0.125M. The implied swap rate is 0.40/DM

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Comparative Advantage Swap Banks 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
  0.3125M for 0.122M ((DM 0.3125M)(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