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Corporate Risk Management

Corporate Risk Management. Currency Swaps. Motivation. Firm A wants to borrow £ Firm B wants to borrow $ Each has existing receivables. Motivation. A is more credit-worthy A has absolute advantage in both $ and £. Motivation. A has comparative advantage in dollars

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Corporate Risk Management

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  1. Corporate Risk Management Currency Swaps

  2. Motivation • Firm A wants to borrow £ • Firm B wants to borrow $ • Each has existing receivables

  3. Motivation • A is more credit-worthy • A has absolute advantage in both $ and £

  4. Motivation • A has comparative advantage in dollars • B has comparative advantage in pounds

  5. Motivation • Swaps work when each firm wants to borrow in currency where other enjoys a comparative advantage

  6. Potential Gain • Potential gain from swap • Difference between the differences in borrowing rates

  7. Potential Gain • Potential gain from swap • Can be divided among firms and intermediary (if used)

  8. Potential Gain • Potential gain from swap • Firm A 0.6% • Firm B 0.6% • Swap Bank 0.4% • 1.6% = potential gain • The distribution of the potential gain among the three parties is negotiated. This is an example.

  9. Mechanics of the Swap • Notional principal • Amount of money the swapped payments are based on • Expressed in both currencies

  10. Mechanics of the Swap • Example • Firm A will borrow $15 million from its lender • Firm B will borrow £10 million from its lender • Current spot XR is 1.5 $/£ • Each firm is borrowing same amount of money

  11. Mechanics of the Swap • Firm A borrows $15 million at 8.0% from its lender • Firm B borrows £10 million at 12.0% from its lender • Firms A and B give principal to Swap Bank which passes it through

  12. Mechanics of the Swap • Firm A pays interest to Swap Bank on £ at 11.0% • Firm B pays interest to Swap Bank on $ at 9.4% • Swap Bank gives A 8.0% on $15 million to pay its lender • Swap Bank gives B 12.0% on £10 million to pay its lender

  13. Results • Firm A borrows £ at 11% instead of 11.6% • Firm B borrows $ at 9.4% instead of 10% • Swap Bank • Receives 11% on £; 9.4% on $ • Pays 12% on £ ; 8% on $ • Net to Swap Bank of 0.4%

  14. Diagram of Currency Swap 11% £ 12% £ 12% £ A Swap Bank B 8% $ 8% $ 9.4% $

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