Currency Swaps
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Overview of the Lecture
1. Definitions
2. Motivation
3. A simple example
4. A real world example
© 1999-2003
1. Definitions
3
Presentation
• There are two main kinds of swaps (currency
and interest rate) but many different
variations exist.
• As a whole, the swaps market is by far the
largest financial derivative market in the
world.
• Currency swap is a long-term
financing/hedging technique. It helps manage
both interest and exchange rate risk.
• It can be viewed as a series of forward
contracts.
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Currency swap
• A currency swap is an agreement to
exchange principal and fixed interest in
one currency for principal and fixed
interest in another currency.
• The initial value of the contract is usual
chosen to be zero.
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Properties
• A currency swap gives the parties to the
contract the right of offset, that is the right to
offset any nonpayment of principal or interest
with a comparative nonpayment.
• A currency swap is not a loan and therefore
does not change the liability structure of the
parties’ balance sheets.
• There is an exchange of principal (unlike for
interest rate swaps).
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A bit of history
• Before 1981 companies were involved in
back-to-back loans where they agreed to
borrow in their domestic currency and lend to
each other these currencies.
• The long-term currency swap transactions
started in August, 1981.
• The World Bank issued $290mln in bonds
and used the dollar proceeds in currency
swaps with IBM for German marks and Swiss
francs.
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2. Motivation: Crosscurrency comparative
advantage
Usual conditions for a
currency swap
• In general, currency swap assumes that one
counterparty borrows under specific terms
and conditions in one currency, while the
other counterparty borrows under different
terms and conditions in a second currency.
• The two counterparties exchange the net
receipts from their respective issues and
agree to service each other’s debt.
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Example 1
Suppose two firms, A and B, can borrow
at the fixed rates of interest as follows:
Firm A
$
10.0%
€
12.2%
Firm B
12.8%
11.0%
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An absolute borrowing
advantage
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• Observe:
– Firm A can pay 2.8% less than firm B on the debt
denominated in U.S. dollars.
– Firm A must pay 1.2% more than firm B on the debt
denominated in euros.
• Therefore:
– Firm A has an absolute advantage in borrowing in the
U.S. dollar market.
– Firm B has an absolute advantage in borrowing in the
euro market.
• The minimum rate in each market could be
reached.
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Example 2
Suppose two firms, A and B, can borrow
at the fixed rates of interest as follows:
Firm A
$
10.0%
€
12.2%
Firm B
11.0%
12.8%
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A comparative borrowing
advantage
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• Observe:
– Firm A can pay full 1.0% less than firm B on the debt
denominated in U.S. dollars.
– Firm A can pay only 0.6% less than firm B on the debt
denominated in euros.
• Therefore:
– Firm A has a comparative advantage in borrowing in
the U.S. dollar market.
– Firm B has a comparative advantage in borrowing in
the euro market.
• The total cost of borrowing could be decreased.
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How does it happen?
• Firm A may be an American company
and/or known better to American
investors and financial institutions.
• Firm B may be a German company
and/or known better to German or
European investors and financial
institutions.
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3. A Simple Example
Firms need financing in a
foreign currency
• Suppose firm A wants to borrow €30M
to finance its new production line in
Germany.
• Suppose firm B wants to borrow $20M
to raise capital for its subsidiary in the
U.S.
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Scenario 1: direct
borrowing
• Firm A borrows € at 12.2%.
• Firm B borrows $ at 11.0%.
• The combined cost of borrowing for two
firms is 12.2+11.0 = 23.2%.
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Scenario 1: initial cash flow 17
diagram
German Bank
€30M
12.2%
U.S. Bank
$20M
11.0%
€30M
$20M
Firm A
Firm B
€30M
$20M
German
Branch
U.S.
Subsidiary
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Scenario 2: indirect
borrowing (with a currency swap)
• Firm A borrows $ at 10.0%.
• Firm B borrows € at 12.8%.
• Firms swap currencies at the beginning and at
the maturity of the contract.
• Firms pay each other’s interest payments.
– Firm A pays firm B 12.8% on €30M, €3.84M.
– Firm B pays firm A 10.0% on $20M, $2M.
• Firm A compensates firm B for borrowing € at
12.8% rather than $ at 11.0%.
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Scenario 2: initial cash flow
diagram
U.S. Bank
$20M
10.0%
German Bank
€30M
12.8%
$20M
€30M
$20M
Firm A
Firm B
€30M
€30M
$20M
German
Branch
U.S.
Subsidiary
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Scenario 2: interest flow
diagram
U.S. Bank
$20M
10.0%
German Bank
€30M
12.8%
$2M
€3.84M
$2M
Firm A
Firm B
€3.84M
€3.84M
$2M
German
Branch
U.S.
Subsidiary
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Scenario 3: final cash flow
diagram
U.S. Bank
$20M
10.0%
German Bank
€30M
12.8%
$20M
€30M
$20M
Firm A
Firm B
€30M
€30M
$20M
German
Branch
U.S.
Subsidiary
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4. A Real World Example:
Kodak’s Zero-Coupon
Australian Dollar Swap
through Merrill Lynch
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Kodak’s financial needs
• It needs at least $75M for 5 years.
• In the U.S. market it can borrow at 7.5%
(50 basis points above U.S. Treasuries).
• Outside the U.S. it can borrow at 7.35%
(35 basis points above U.S. Treasuries).
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Merrill Lynch’s market
analysis
• Investor interest in non-dollar issues is much
stronger in Europe than in the U.S.
• Kodak should issue a Eurobond debt
dominated in a currency different from the
U.S. dollar.
• Australian zero-coupon issue is selling very
well in Europe.
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The beginning
• Kodak issues a A$200M zero-coupon, 5-year
Eurobond.
• Net proceeds to Kodak were A$106M or 53%
of A$200M.
• What is the Kodak’s cost of the Eurobond
A$200
issue?
A$106 
5
1  r$A 
r$A  13.5%
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What can Kodak do? alternative 1
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• Kodak can obtain its desired $75M by
converting A$106M at the $/A$ =
0.7059.
• Kodak is exposed to fluctuations in the
value of the Australian dollar against the
U.S. dollar.
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What can Kodak do? alternative 2
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• Kodak enters into a 5-year swap contract with
Merrill Lynch.
• At the beginning of the contract, Kodak swaps
A$106M for $75M.
• Over the life of the contract, Kodak pays 7.35%
of $75M ($2,756,250 semiannually) to Merrill
Lynch.
• At the maturity of the contract, Kodak swaps
$75M back for A$106M.
• Kodak’s currency risk exposure is eliminated.
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The position of Merrill
Lynch
• The currency risk is fully transferred
from Kodak to Merrill Lynch.
• Is Merrill Lynch happy with that? No.
• What can Merrill Lynch do? It can enter
into a currency swap with a party that is
willing to pay $ in exchange for A$.
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•
Merrill Lynch’s currency
swap
conditions
Merrill Lynch enters into a swap contract with an
Australian Bank agreeing to make semiannual
payments of LIBOR less 40 basis points.
• The Australian bank cannot swap A$200M. It
can only swap A$130M and pay Merrill Lunch
13.39% semiannually.
• Merrill Lynch still has currency exposure
because it is left with A$70M (A$200MA$130M).
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Merrill Lynch’s next step
• Merrill Lynch exchanges the remaining A$38M
(A$106M-A$68M) for $27M in the spot market.
• Merrill Lynch enters into a forward contract with
the Australian bank to exchange $37M for
A$70M in five years at the rate $/A$ = 0.5286.
• Now Merrill Lynch is no longer exposed to
currency risk.
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Merrill Lynch’s last risk
exposure
• Merrill Lunch is exposed to interest rate risk.
• Where does this risk come from? From Merrill
Lynch’s floating rate obligations on the A$68M
for $48M swap with the Australian bank.
• What can Merrill Lynch do? It can enter into an
interest rate swap with a party that is willing to
pay a floating rate and receive a fixed rate.
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Conclusions
• Currency swaps provide real benefits to both
parties.
• Currency swaps are beneficial when there exist
cross-country barriers to full arbitrage.
• Currency swaps are useful when long-term
capital is needed and the forward foreign
exchange markets are not well developed.
© 1999-2003