Currency Swaps

1. Currency Swaps Fin 286

2. Currency Swaps • The primary purpose of a currency swap is to transform a loan denominated in one currency into a loan denominated in another currency. • In a currency swap, a principal must be specified in each currency and the principal amounts are exchanged at the beginning and end of the life of the swap. • The principal amounts are approximately equal given the exchange rate at the beginning of the swap.

3. A simple example Assume that company A pays a fixed rate of 11% in sterling and receives a fixed interest rate of 8% in dollars. Let interest payments be made once a year and the principal amounts be $15 million and L10 Million Company A Dollar Cash Sterling Cash Flow (millions) Flow (millions) 2/1/1999 -15.00 +10.00 2/1/2000 +1.20 -1.10 2/1/2001 +1.20 -1.10 2/1/2002 +1.20 -1.10 2/1/2003 +1.20 -1.10 2/1/2004 +16.20 -11.10

4. Intuition • Suppose A could issue bonds in the US for 8% interest, the swap allows it to use the 15 million to actually borrow 10 million sterling at 11% (A can invest L 10M @ 11% but is afraid that $ will strength it wants US denominated investment)

5. Comparative Advantage • It is likely that the domestic firm has an advantage in borrowing in its home country. • Therefore both can benefit from the swap and lower their borrowing cost.

6. Example using comparative advantage Dollars AUD (Australian $) Company A 5% 12.6% Company B 7% 13.0% 2% difference in $US .4% difference in AUD

7. The strategy • Company A borrows dollars at 5% per annum • Company B borrows AUD at 13% per annum They enter into a swap Result Since the spread between the two companies is different for each firm there is the ability of each firm to benefit from the swap. We would expect the gain to both parties to be 2 - 0.4 = 1.6% (the differences in the spreads).

8. Swap Diagram Co A FI Co B A pays 11.9% AUD instead of 12.6% AUD B pays 6.3% $US instead of 7% $US The FI makes .2% AUD 11.9% AUD 13% 5% AUD 13% 5% 6.3%

9. Valuation of Currency Swaps • Using Bond Techniques • Assuming there is no default risk the currency swap can be decomposed into a position in two bonds, just like an interest rate swap. • In the example above the company is long a sterling bond and short a dollar bond. The value of the swap would then be the value of the two bonds adjusted for the spot exchange rate.

10. Swap valuation • Let S = the spot exchange rate at the beginning of the swap, BF is the present value of the foreign denominated bond and BD is the present value of the domestic bond. Then the value is given as Vswap = SBF – BD The correct discount rate would then depend upon the term structure of interest rates in each country

11. Other swaps • Swaps can be constructed from a large number of underlying assets. • Instead of the above examples swaps for floating rates on both sides of the transaction. • The principal can vary through out the life of the swap. • They can also include options such as the ability to extend the swap or put (cancel the swap). • The cash flows could even extend from another asset such as exchanging the dividends and capital gains realized on an equity index for a fixed or floating rate.

12. Commodity Swaps • Assume that an energy firm anticipates buying 100,000 barrels of oil 1 year from today and two years from today. • Option 1: enter into long forward contracts for Oil setting the price at $20 in one year and $21 in two years. Given the 1 year and 2 year interest rate, the per barrel PV of this is equal to: The firm could invest $37.383 today and guarantee it had the money to buy oil in each year The Discussion of Commodity Swaps follows the material in Derivative Markets by McDonald