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IBUS 302: International Finance

Topic 15-Currency Swaps

Lawrence Schrenk, Instructor.

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Learning Objectives

1. Describe a currency swap and the motives for using it.▪

2. Calculate the cash flows in a currency swap.

3. Calculate the value of a swap.▪

What is a Swap?

Contract between counterparties to exchange cash flows.

Notional Amount Maturity Legs Etc…

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Types of Swaps

Interest Rate Fixed for floating interest rate

Currency One currency for another currency

Commodity Swaps Equity Swaps

NOTE: Distinguish swaps from a ‘swap transaction’ (Chapter 5) and a credit default swap (CDS).

Currency Swaps

Exchange Cash Flows in Different Currencies Bond Cash Flows Principal Exchanged at Beginning and at End Normally, Fixed Rate Coupon

Straight Swap Currency Trade which is Reversed at Later Date Interest Payments

Debt Payment Swap

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Uses

Conversion from a liability in one currency to a liability in another currency.

Conversion from an investment in one currency to an investment in another currency.

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Swap Motivations

Lower Costs of Capital Hedge FX Risk

Comments Compare with international bonds. Why not hedge?

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Swap Risks

Price Risk FX Rates can Change

Counterparty Risk Disputes over payments

Market Valuation Risk FASB requires all derivatives, including

swaps, to be stated at fair market value.

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Currency Swap Example

Firm US wants to issues bonds to fund a subsidiary in England. The subsidiary will need its initial capital in

pounds, and The subsidiary will generate pounds to pay the

interest and principal.

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Currency Swap Example (cont’d)

Should Firm US issues the bonds in dollars or pounds? ▪ Pounds

Pro: No Currency Risk Con: Higher Cost of Debt

Dollars Pro: Lower Cost of Debt Con: Long-Term Currency Risk–could it be hedged? ▪

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Currency Swap Example (cont’d)

Firm US Would like to Issue Pound (£) Bonds But Dollar ($) Borrowing has Lower Cost of Debt

Firm UK Would like to Issue Dollar ($) Bonds But Pound (£) Borrowing has Lower Cost of Debt

Swap Opportunity…

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Currency Swap Example (cont’d)

Solution: The firms ‘swap’ the debt cash flows. Firm US

Issues Dollar ($) Bonds This captures the Firm US’s advantage in dollar

borrowing. Exchanges All Debt Cash Flows with Firm UK

Firm US now has the pound (£) cash flows it wants.

Firm UK does the reverse

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Currency Swap Example (cont’d)

Loosely Firm US does the dollar borrowing for Firm UK

Firm UK services that dollar debt Firm UK does the pound borrowing for Firm US

Firm US services that pound debt

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Currency Swap Example (cont’d)

Assumptions S($/£) 1.50 Principal $15,000,000 (= £10,000,000) Maturity 3 years Coupon Annual

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Currency Swap Example (cont’d)

Assumptions Firm US

r$ 8% (Coupon = $1,200,000)

r£ 13% (Coupon = £1,300,000) Firm UK

r$ 14% (Coupon = $2,100,000)

r£ 11% (Coupon = £1,100,000)

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Currency Swap Example (cont’d)

Firm US ▪

$ £

Borrows $15

Gives $15 Gets £10

Gets $1.2/year Gives £1.1/year

Gets $15 Gives £10

Repays $15 ▪

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t =

3

t

= 1

-3

t

= 0

Currency Swap Example (cont’d)

Firm US

Year CF$ CF£

0 - 15.0 + 10.0

1 + 1.2 - 1.1

2 + 1.2 - 1.1

3 + 16.2 - 11.1

Year 3: 16.2 = 15 + 1.2 and 11.1 = 10 + 1.1

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‘Implicit’ Exchange Rates

Principal (at Start) Exchanged at S($/£) = 1.50

Interest Payments Implicit Exchange rate of

Principle and Interest (at Maturity)

Implicit Exchange rate of

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£16.21.4595

$11.1

£1.21.0909

$1.1

Is this Fair?

Firm UK Borrows Pounds at 11% But Only Pays Dollars at 8%

Firm US Borrows Dollars at 8% But Must Pay Pounds at 8%

Is this fair to Firm US?

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Interest Rate Parity

You cannot forget IRP Interest Rates Are Higher in the UK than US IRP: Pound will Depreciate; Dollar will Appreciate IRP says that FX changes will compensate any

differences in interest rates. Firm US appears to be paying more, but it is

paying in a currency (£) that is depreciating. Firm US: The higher interest rate is

counterbalanced by currency depreciation.

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Comparative Advantage

What is a Comparative Advantage? David Ricardo and his Free Trade Argument

Chapter 1, Appendix for Details

Swaps Interest Rate Gains from a Swap only Require

a… Comparative Advantage

NOTE: Swaps hedge currency exposure (in addition to any interest rate gains).

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Swap Valuation (cont’d)

The Value of a Swap is the value of One Leg (minus) The Other Leg

In Algebraic Terms: V$ = B£ x S($/£) – B$

V$ = Value of the Swap (in dollars)

B£ = Value of the Pound Bond

B$ = Value of the Dollar Bond

Note: The currency units cancel to leave dollars.22 (of 26)

Swap Valuation (cont’d)

To find the Value of Each Bond Discount the Cash Flows (Just Like in FIN 365).

Dollar Bond Value

Pound Bond Value

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$ 2 3

1.2 1.2 16.215 0

1.08 1.08 1.08B

£ 2 3

1.1 1.1 11.110 0

1.11 1.11 1.11B