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Currency Swap: Definition
A currency swap is an 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 euros.
French corporation with operations in the US can
obtain comparatively better terms by borrowing
euros, 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
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, 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.
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Example
To meet each other's needs, suppose that both
companies go to a swap bank that sets up the following
agreements:
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Example
Agreement 1:
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.
2. 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.
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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 companys swap
position where dollars are received and sterling is paid
is
where:
B
$
= Dollar-Denominated Bond Value
B
80 . 1 $
000 , 500
000 , 900 $
E
f
= =
Comparative Advantage:
Swap Banks 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.
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Comparative Advantage:
Swap Banks 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:
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T
BP
$
0 fT
R 1
R 1
E E
|
|
.
|
\
|
+
+
=
/ 683616 . 1 $
07 . 1
095 . 1
) / 50 . 1 ($ E : 5 T
/ 645177 . 1 $
07 . 1
095 . 1
) / 50 . 1 ($ E : 4 T
/ 607616 . 1 $
07 . 1
095 . 1
) / 50 . 1 ($ E : 3 T
/ 570912 . 1 $
07 . 1
095 . 1
) / 50 . 1 ($ E : 2 T
/ 535047 . 1 $
07 . 1
095 . 1
) / 50 . 1 ($ E : 1 T
5
f
4
f
3
f
2
f
1
f
=
|
.
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\
|
= =
=
|
.
|
\
|
= =
=
|
.
|
\
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= =
=
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.
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= =
=
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.
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= =
Comparative Advantage:
Swap Banks 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 banks 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 Banks Hedge
Swap Banks Hedged Position
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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
Comparative Advantage:
Swap Banks 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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