IBUS 302:
International Finance
Topic 15-Currency Swaps
Lawrence Schrenk, Instructor
.
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Learning Objectives
1.
2.
3.
Describe a currency swap and the motives
for using it.▪
Calculate the cash flows in a currency
swap.
Calculate the value of a swap.▪
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What is a Swap?





Contract between counterparties to exchange
cash flows.
Notional Amount
Maturity
Legs
Etc…
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Types of Swaps

Interest Rate


Currency



Fixed for floating interest rate
One currency for another currency
Commodity Swaps
Equity Swaps
NOTE: Distinguish swaps from a ‘swap transaction’
(Chapter 5) and a credit default swap (CDS).
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Currency Swaps

Exchange Cash Flows in Different Currencies




Straight Swap



Bond Cash Flows
Principal Exchanged at Beginning and at End
Normally, Fixed Rate Coupon
Currency Trade which is Reversed at Later Date
Interest Payments
Debt Payment Swap
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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.
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Swap Motivations

Lower Costs of Capital
Hedge FX Risk

Comments



Compare with international bonds.
Why not hedge?
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Swap Risks

Price Risk


Counterparty Risk


FX Rates can Change
Disputes over payments
Market Valuation Risk

FASB requires all derivatives, including
swaps, to be stated at fair market value.
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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.
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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? ▪
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Currency Swap Example
(cont’d)

Firm US



Firm UK



Would like to Issue Pound (£) Bonds
But Dollar ($) Borrowing has Lower Cost of Debt
Would like to Issue Dollar ($) Bonds
But Pound (£) Borrowing has Lower Cost of Debt
Swap Opportunity…
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Currency Swap Example
(cont’d)


Solution: The firms ‘swap’ the debt cash flows.
Firm US

Issues Dollar ($) Bonds


Exchanges All Debt Cash Flows with Firm UK


This captures the Firm US’s advantage in dollar
borrowing.
Firm US now has the pound (£) cash flows it wants.
Firm UK does the reverse
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Currency Swap Example
(cont’d)

Loosely

Firm US does the dollar borrowing for Firm UK


Firm UK services that dollar debt
Firm UK does the pound borrowing for Firm US

Firm US services that pound debt
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Currency Swap Example
(cont’d)

Assumptions




S($/£)
Principal
Maturity
Coupon
1.50
$15,000,000 (= £10,000,000)
3 years
Annual
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Currency Swap Example
(cont’d)

Assumptions


Firm US
 r$
8%
 r£
13%
Firm UK
 r$
14%
 r£
11%
(Coupon = $1,200,000)
(Coupon = £1,300,000)
(Coupon = $2,100,000)
(Coupon = £1,100,000)
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Gets £10
t = 1-3
$
Borrows $15
Gives $15
Firm US ▪
£
Gets $1.2/year
Gives £1.1/year
t=3
t=0
Currency Swap Example
(cont’d)
Gets $15
Repays $15 ▪
Gives £10
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Currency Swap Example
(cont’d)
Year
0
1
2
3
Firm US
CF$
- 15.0
+ 1.2
+ 1.2
+ 16.2
CF£
+ 10.0
- 1.1
- 1.1
- 11.1
Year 3: 16.2 = 15 + 1.2 and 11.1 = 10 + 1.1
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‘Implicit’ Exchange Rates

Principal (at Start)


Interest Payments


Exchanged at S($/£) = 1.50
Implicit Exchange rate of £1.2
 1.0909
$1.1
Principle and Interest (at Maturity)

Implicit Exchange rate of £16.2
$11.1
 1.4595
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Is this Fair?

Firm UK



Firm US



Borrows Pounds at 11%
But Only Pays Dollars at 8%
Borrows Dollars at 8%
But Must Pay Pounds at 8%
Is this fair to Firm US?
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Interest Rate Parity

You cannot forget IRP

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
Interest Rates Are Higher in the UK than US
IRP: Pound will Depreciate; Dollar will Appreciate
IRP says that FX changes will compensate any
differences in interest rates.
Firm US appears to be paying more, but it is
paying in a currency (£) that is depreciating.
Firm US: The higher interest rate is
counterbalanced by currency depreciation.
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Comparative Advantage

What is a Comparative Advantage?

David Ricardo and his Free Trade Argument


Chapter 1, Appendix for Details
Swaps


Interest Rate Gains from a Swap only Require a…
Comparative Advantage
NOTE: Swaps hedge currency exposure (in addition to
any interest rate gains).
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Swap Valuation (cont’d)

The Value of a Swap is the value of



One Leg (minus)
The Other Leg
In Algebraic Terms:

V$ = 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.
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Swap Valuation (cont’d)

To find the Value of Each Bond

Discount the Cash Flows (Just Like in FIN 365).

Dollar Bond Value
1.2
1.2
16.2
B$  15 


0
2
3
1.08 1.08 1.08 

Pound Bond Value
1.1
1.1
11.1
B£  10 


0
2
3
1.11 1.11 1.11
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