Infrastructure Project Finance Global Capital Markets

Professor Robert B.H. Hauswald Kogod School of Business, American University

Case Study: Reading Instructions

Currency Swaps

Swaps are one of the most important risk management instruments in finance. They involve the
exchange of one liability for another one which allows market participants to optimally disassemble
and redistribute risks. What is less appreciated is that swaps also allow the parties to benefit from
arbitrage opportunities in fixed income markets that can significantly lower borrowing costs. Last
but not least, swaps are a crucial ingredient in financial engineering; indeed, the field developed
from cash flow engineering that arose in the early analysis of swaps, straight bonds and floating
rate notes.
Swaps come in two important flavors: interest rate swaps (fixed-for-floating) and (foreign)
currency swaps. Our objective is to use swaps for risk management purposes and synthetic finance.
The present note contains the relevant material on FX that corresponds to the treatment of interest
rate swaps in FIS 161 which should be read together.
In answering the following questions you should refer to both Currency Swaps and FIS. Please
look at all the points which will facilitate the understanding and subsequent discussion of the case.

1. Where did the swap market originate? Why?

2. Why are swaps so popular? What is their economic rationale?

3. How would you define a currency swap?

(a) What are its mechanics?

(b) Draw a cash flow diagram for the World Bank - IBM USD-CHF transaction.
(c) What role, if any, do ratings play in swaps?

4. Analyze the World Bank - IBM USD-CHF FX swap.

(a) Define absolute advantage. Who holds the absolute advantage and why?
(b) Define comparative advantage. Who has the comparative advantage in each segment?
(c) What are the gains from the swap to be shared between the parties?

5. Where do the gains from swaps arise from? Find at least three different reasons. What are
they all related to?

6. Where does one use foreign exchange (FX) rates in setting up FX swaps?

7. What are the differences and similarities between FX and interest rate swaps?
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Tuckman, (2002), Fixed Income Securities, 2nd ed., Wiley.
8. What is the combination of FX and interest rate swaps called? How many swap types can
you construct by mixing the basic flavors?

9. Swaps are important risk management tools. How would you use swaps in the following
situations (give an example and describe the swap type):

(a) your company has a USD fixed rate exposure but needs a fixed rate JPY exposure;
(b) your company has a variable interest JPY loan and wishes to lock in historically low
Japanese interest rates by converting the exposure to a JPY fixed rate one;
(c) your company has a HKD fixed rate exposure but wishes to have a AUD floating rate
one.