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Currency Swaps

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.

• A German corporation with operations in India can


obtain comparatively better terms by borrowing
euros, but prefers a loan in Rupees.

• The two companies could go to a swap bank who


could arrange for a loan swap.
Example
 As a example, suppose the British Petroleum Company
plans to issue five-year bonds worth £100 million at
7.5% interest, but actually needs an equivalent amount
in dollars, $150 million (current $/£ rate is $1.50/£), to
finance its new refining facility in the U.S.

 Also, suppose that the Piper Shoe Company (fictitious


name), a U. S. company, plans to issue $150 million in
bonds at 10%, with a maturity of five years, but it really
needs £100 million to set up its distribution center in
London.
Example
 To meet each other's needs, suppose that both
companies go to a swap bank that sets up the following
agreements:
Example
Agreement 1:
 The British Petroleum Company will issue 5-year £100
million bonds paying 7.5% interest. It will then deliver
the £100 million to the swap bank who will pass it on to
the U.S. Piper Company to finance the construction of its
British distribution center.

 The Piper Company will issue 5-year $150 million bonds.


The Piper Company will then pass the $150 million to
swap bank that will pass it on to the British Petroleum
Company who will use the funds to finance the
construction of its U.S. refinery.
Example
Agreement 2:
1. The British company, with its U.S. asset (refinery), will
pay the 10% interest on $150 million ($15 million) to the
swap bank who will pass it on to the American company
so it can pay its U.S. bondholders.

2. The American company, with its British asset


(distribution center), will pay the 7.5% interest on £100
million ((.075)( £100m) = £7.5 million), to the swap bank
who will pass it on to the British company so it can pay
its British bondholders.

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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.

2. At maturity, the American company will pay £100


million to the swap bank who will pass it on to the
British company so it can pay its British bondholders.

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Valuation
Equivalent Bond Position
Equivalent Bond Position

In the above swap agreement, the American company will


receive $15 million each year for five years and a principal
of $150 million at maturity and will pay £7.5 million each
year for five years and £100 million at maturity.

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Valuation
Equivalent Bond Position
Equivalent Bond Position
 To the American company, this swap agreement is
equivalent to a position in two bonds:

1. A long position in a dollar-denominated, five-year,


10% annual coupon bond with a principal of $150
million and trading at par

2. A short position in a sterling-denominated, five-


year, 7.5% annual coupon bond with a principal of
£100 million and trading at par

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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

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Valuation
Equivalent Bond Position

The dollar value of the swap to the American Company in


terms of equivalent bond positions is zero:

SV = $150 million – ($1.50/£)(£100 million) = 0

This is true at the initiation of the swap. Remember the


Interest Rate Swaps where at commencement, the value
of the swap was zero.

Question : if at initiation, the value of the swap is not


zero – what to do ?
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Valuation
Equivalent Bond Position
The British company’s swap position in which it will
receive sterling and pay dollars is just the opposite of the
American’s position.

It is equivalent to a long position in a sterling-denominated


bond and short position in a dollar denominated bond. In
this example, it likewise has a value of zero.

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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.

Given this hedge, a currency swap, like an interest rate


swap, generally has an economic value of zero when it is
created.

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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 value of a dollar received/foreign currency paid


swap is inversely related to U.S. interest rates and the
exchange rate and directly related to the foreign rate.

• The value of a foreign currency received/dollar paid


swap, valued in dollars, is directly related to U.S. rates
and the exchange rate and inversely related to the foreign
rate.
Valuation
Equivalent Forward Exchange Position

Equivalent Forward Exchange Position

Instead of viewing its swap as a bond position, the British company


could alternatively view its interest agreement to pay $15 million for
£7.5 million each year for five years and it principal agreement to pay
$150 million for £100 million at maturity as a series of long currency
forward contracts in years 1, 2, 3, 4, and 5.

In contrast, the American company could view its swap agreements to


sell £7.5million each year for $15 million and sell £100 million at
maturity for $150 million as a series of short currency forward
contracts.
Valuation
Equivalent Forward Exchange Position

Equivalent Forward Exchange Position


In the absence of arbitrage, the value of the American
company’s swap of dollar’s received/British pounds paid
should be equal to:

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.

The dollar value of the British position is just the opposite.


Valuation
Equivalent Forward Exchange Position

Equivalent Forward Exchange Position

Note that in the absence of arbitrage, the values of the swap


positions as forward contracts are equal to their values as
bond positions:
M
($ Re ceived )  E ft (FC Paid )
SV  
t 1 (1  R US ) t
 B$  E 0 BFC
Comparative Advantage
 The currency swap in the above example
represents an exchange of equivalent loans.

 Most currency swaps, though, are the result of


financial and non-financial corporations
exploiting a comparative advantage resulting from
different rates in different currencies for different
borrowers.
Comparative Advantage: Example

Example

 Suppose the American and British companies have


access to both British (GBP) and American ($)
lending markets.

 Suppose the American company is more


creditworthy and can obtain lower rates than the
British company in both the US and British
markets.
Comparative Advantage: Example

Example:

 Suppose the American company can obtain 10%


U.S. dollar-denominated loans in the U.S. market
and 7.25% sterling-denominated loans in the
British market, whereas the best the British
company can obtain is 11% in the U.S. market and
7.5% in the British market.

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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.

 The British company has a comparative advantage in the


British market:
 It pays .25% more than the American company in the
British market, compared to 1% more in the US
market.
Comparative Advantage: Example

 When a comparative advantage exist, a swap


bank is in a position to benefit one or both
parties.

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Comparative Advantage: Example

Example:
Suppose in this case a swap bank sets up the following
swap arrangement:

The American company borrows $150 million at 10%,


and then agrees to swap it for £100 million loan at
7%.

The British company borrows £100 million at 7.5%,


and then agrees to swap it for $150 million loan at
10.6%.

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Comparative Advantage: Example

(a) Initial Cash Flow

British American
Bondholder Bondholder
£100m $150m

British £100m £100m


Swap American
Company $150m Bank Company
$150m
$150m £100m

British Company ' s American Company ' s


American Asset British Asset

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Comparative Advantage: Example

(b) Annual Interest Cash flow

British American
Bondholder Bondholder
£7.5m
$15m

British (£100m)(.075)  £7.5m Swap (£100m)(.07)  £7m American


Company Bank Company
(.106)($150)  $15.9m (.10)($150m)  $15m

$15.9m £7.5m

British Company ' s American Company ' s


American Asset British Asset

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Comparative Advantage: Example

(c) Principal Payment at Maturity

British American
Bondholder Bondholder
£100m $150m

British £100m £100m


Swap American
Company $150m Bank Company
$150m
$150m £100m

British Company ' s American Company ' s


American Asset British Asset

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Comparative Advantage:
Swap Bank’s Position
In this swap arrangement:

The American company benefits by paying 0.25% less


than it could obtain by borrowing British pounds
directly in the British market

The British company gains by paying 0.4% less than it


could obtain directly from the U.S. market.

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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.

On the other hand, the swap bank will receive only £7


million from the American company, while having to pay
£7.5 million to the British company, for a net sterling
payment of £0.5 million.

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Comparative Advantage:
Swap Bank’s Position

Swap Bank’s Position:


Swap Bank’s $ Position Swap Bank’s £ Position

Receives: (.106)($150,000,000) = $15,900,000 Receives: (.07)(£100,000,000) = £7,000,000


Pays: −(.10)($150,000,000) = −$15,000,000 Pays: (.075)(£100,000,000) = −£7,500,000
Net $ Receipt: $900,000 Net £ Payment: −£500,000

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Comparative Advantage:
Swap Bank’s Position

 Thus, the swap bank has a position equivalent to a


series of long currency forward contracts in which it
agrees to buy £500,000 for $900,000 each year. The
swap bank's implied forward rate on each of these
contracts is $1.80/£:

$900,000 $1.80
Ef  
£500,000 £
Comparative Advantage:
Swap Bank’s Position

The swap bank can hedge its position with currency


forward contracts.

If the forward rate is less than $1.80/£, then the bank


could gain from hedging the swap agreement with
forward contracts to buy £500,000 each year each year for
the next five years.
Comparative Advantage:
Swap Bank’s Position
 For example, suppose the yield curves applicable for the swap bank are
flat at 9.5% in the U.S. dollars and 7% in pounds (assume annual
compounding). Using the interest rate parity relation, the one-, two-,
three-, four-, and five-year forward exchange rates would be:
1
 1.095 
T  1 : E f  ($1.50 / £ )   $1.535047 / £
 1 R $ 
T
 1.07 
E fT  E 0   2
 1  R BP   1.095 
T  2 : E f  ($1.50 / £ )   $1.570912 / £
 1.07 
3
 1.095 
T  3 : E f  ($1.50 / £ )   $1.607616 / £
 1 . 07 
4
 1.095 
T  4 : E f  ($1.50 / £ )   $1.645177 / £
 1.07 
5
 1.095 
T  5 : E f  ($1.50 / £ )   $1.683616 / £
 1 . 07 
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Comparative Advantage:
Swap Bank’s Position

 The swap bank could enter into forward contracts to buy


£500,000 each year for the next five years at these
forward rates.

 With all of the forward rates less than implied forward


rate of $1.80/£, the bank’s dollar costs of buying
£500,000 each year would be less than its $900,000
annual inflow from the swap.

 By combining its swap position with forward contracts,


the bank would be able to earn a total profit from the
deal of $478,816.
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Comparative Advantage:
Swap Bank’s Hedge
 Swap Bank’s Hedged Position
1 2 3 4 5 6
Year $ Cash Flow £ Cash Flow Forward Exchange: $/£ $ Cost of Sterling Net $ Revenue
Column (2) X Column (3) Column (4) X Column (3) Column (2) - Column (5)
1 $900,000 £500,000 $1.535047 -$767,524 $132,477
2 $900,000 £500,000 $1.570912 -$785,456 $114,544
3 $900,000 £500,000 $1.607616 -$803,808 $96,192
4 $900,000 £500,000 $1.645177 -$822,589 $77,412
5 $900,000 £500,000 $1.683616 -$841,808 $58,192
$478,816

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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).

The bank could do this by borrowing $700,935 (= ($1.50/£) (£467,290)) at


9.5%, converting it to £467,290, and investing the sterling at 7% interest for the
next year.

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.
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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.

 Based on these different rates, they will arrange swaps that


provide each borrower with rates better than the ones they can
directly obtain and a profit for them that will compensate them
for facilitating the deal and assuming the credit risk of each
counterparty.

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Non-Generic Currency Swaps

The generic currency swap has been modified to


accommodate different uses.

Of particular note is the cross-currency swap that is a


combination of the currency swap and interest rate swap.
 This swap calls for an exchange of floating-rate payments in
one currency for fixed-rate payments in another.

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Non-Generic Currency Swaps

 Non-Generic Currency Swaps:


1. Currency swaps with amortizing principals
2. Cancelable and extendable currency swaps
3. Forward currency swaps
4. Options on currency swaps

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