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IBUS 302: International Finance

IBUS 302: International Finance. Topic 15-Currency Swaps Lawrence Schrenk, Instructor. Learning Objectives. Describe a currency swap and the motives for using it. ▪ Calculate the cash flows in a currency swap. Calculate the value of a swap. ▪. What is a Swap?.

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IBUS 302: International Finance

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  1. IBUS 302: International Finance Topic 15-Currency Swaps Lawrence Schrenk, Instructor .

  2. Learning Objectives • Describe a currency swap and the motives for using it.▪ • Calculate the cash flows in a currency swap. • Calculate the value of a swap.▪

  3. What is a Swap? • Contract between counterparties to exchange cash flows. • Notional Amount • Maturity • Legs • Etc…

  4. 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).

  5. 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

  6. 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.

  7. Swap Motivations • Lower Costs of Capital • Hedge FX Risk • Comments • Compare with international bonds. • Why not hedge?

  8. 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.

  9. 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.

  10. 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? ▪

  11. 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…

  12. 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

  13. 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

  14. Currency Swap Example (cont’d) • Assumptions • S($/£) 1.50 • Principal $15,000,000 (= £10,000,000) • Maturity 3 years • Coupon Annual

  15. 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)

  16. 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 ▪ t = 3 t = 1-3 t = 0

  17. 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

  18. ‘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

  19. 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?

  20. 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.

  21. 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).

  22. 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.

  23. 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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