Académique Documents
Professionnel Documents
Culture Documents
International Finance
Goa Institute of Management
Currency Swap: Definition
A currency swap is an exchange of a liability in one
currency for a liability in another currency.
Nature:
• An Indian corporation with operations in Europe
can obtain comparatively better terms by
borrowing Rupees, but prefers a loan in Euros to
assist its European ops.
6
Example
Agreement 3:
1. At maturity, the British company will pay $150 million
to the swap bank who will pass it on to the American
company so it can pay its U.S. bondholders.
7
Valuation
Equivalent Bond Position
Equivalent Bond Position
8
Valuation
Equivalent Bond Position
Equivalent Bond Position
To the American company, this swap agreement is
equivalent to a position in two bonds:
9
Valuation
Equivalent Bond Position
The dollar value of the American company’s swap
position where dollars are received and sterling is paid is
SV B$ E 0 B£
where:
B$ = Dollar-Denominated Bond Value
B£ = Sterling-Denominated Bond Value
E0 = Spot Exchange Rate = $/BP
10
Valuation
Equivalent Bond Position
12
Valuation
Equivalent Bond Position
If a dealer had been warehousing swaps and provided a
swap to just the American company, then it could have
hedged its swap position of paying $15 million and
receiving £7.5 million by shorting the 7.5% sterling-
denominated bond and buying the 10% U.S. dollar-
denominated bond.
13
Valuation
Equivalent Bond Position
• The zero economic value of the swap positions will
change over time with changes in U.S. rates, British
rates, and the spot exchange rate.
The sum the present values of $15 million received each year from the
swap minus the dollar cost of buying £7.5 million at the forward
exchange rate (Eft).
The present value of the $150 million received at year five minus the
dollar cost of buying £100 million at the five-year forward exchange
rate.
Example
Example:
20
Comparative Advantage: Example
Loan Rates for American and British
Companies in Dollars and Pounds
Spot: E0 = $/£ = $1.50/£
Dollar Market Pound Market
(rate on $) (rate on £)
American Company 10% 7.25%
British Company 11% 7.5%
Comparative Advantage: Example
Example
The American company has a comparative advantage in
the US market:
It pays 1% less than the British company in the US
market, compared to only .25% less in the British
market.
23
Comparative Advantage: Example
Example:
Suppose in this case a swap bank sets up the following
swap arrangement:
24
Comparative Advantage: Example
British American
Bondholder Bondholder
£100m $150m
25
Comparative Advantage: Example
British American
Bondholder Bondholder
£7.5m
$15m
$15.9m £7.5m
26
Comparative Advantage: Example
British American
Bondholder Bondholder
£100m $150m
27
Comparative Advantage:
Swap Bank’s Position
In this swap arrangement:
28
Comparative Advantage:
Swap Bank’s Position
The swap bank in this case will receive $15.9 million each
year from the British company, while only having to pay
$15 million to the American company, for a net dollar
receipt of $ 0.9 million.
29
Comparative Advantage:
Swap Bank’s Position
30
Comparative Advantage:
Swap Bank’s Position
$900,000 $1.80
Ef
£500,000 £
Comparative Advantage:
Swap Bank’s Position
35
Comparative Advantage:
Swap Bank’s Hedge
Instead of forward contracts, the swap bank also could hedge its swap position
by using a money market position.
For example, on its first sterling liability of £500,000 due in one year, the bank
would need to create a sterling asset worth £500,000 one year later (current
value of £467,290M = £500,000/1.07) and a dollar liability worth $764,524
(based on the forward contract).
One year later, the bank would have £500,000 (= £467,290(1.07)) from the
investment to cover its sterling swap liability and would have a dollar liability
of $767,524 (= $700,935(1.095)), which is less than the $900,000 dollar inflow
from the swap.
The bank would thus earn a profit of $132,476 (= $900,000 −$767,524) from
the hedged cash flow – the same profit it would earn from hedging with the
forward exchange contracts if the interest rate parity relation holds.
36
Summary
The presence of comparative advantage creates a currency swap
market in which swap banks look at the borrowing rates offered
in different currencies to different borrowers and at the forward
exchange rates and money market rates that they can obtain for
hedging.
37
Non-Generic Currency Swaps
38
Non-Generic Currency Swaps
39