2011` EXAMINATION QUESTION (6)
(6a) What factors do matter in determining the appropriate
mix of equity and debt financing for parent and affiliates?
(3 marks)
1
2011 EXAMINATION Q & A (6a)
•
•
•
•
Parent’s cost of equity
Parent’s after-tax cost of credit
Parent’s debt-equity ratio
Foreign subsidiary: withholding tax on repatriated proftits,
corporate tax
• Local currency outlook (strength/weakness, possible
devaluation/depreciation)
• Cost of local borrowing by the foreign subsidiary
2
2011 EXAMINATION QUESTION (6)
(6 b) Suppose a new foreign investment project in Vietnam requires MYR
100m of which (i) MYR 30m comes from parent co in Malaysia, (ii) MYR
20m from retained earnings of foreign subsidiary in Vietnam, and (iii)
MYR 50m in the form of debt financing in the host country. Assume the
following:
(i) parent’s cost of equity (Kep) is 16%;
(ii) parent’s after-tax cost of debt is 6%;
(iii) parent’s debt-equity ratio is 30%;
(iv) Foreign subs in Vietnam is subject to 8% w-tax on repatriated profits
and 40% corporate tax;
(v) Local currency of foreign subs (dong) is expected to devalue in the
foreseeable future by 7%; and
(vi) (vi) local interest rate (in Vietnam) is 20%.
Based on the above information, compute the correct “K” (WACC) to be
used by parent in discounting the new project.
(8 marks)
3
2011 EXAMINATION Q&A (6b)
• 3 components:
(1) Parent’s cost of capital = [Kep (equity ratio) + Kdp (debt ratio)
(2) Cost of Subs RE = [Kep (1-withholding tax)]
(3) Cost of new foreign debt = [(1 + int rate/1 + likely currency devn)] – 1 x
(1- corporate tax)
Computation:
(1) 0.16 (0.7) + 0,06 (0.3) = 0.13
(2) 0.16 (1-0.08) = 0.1472
(3) (1.20/1.07) – 1 = 0.1215 x (1-0.4) = 0.0729
Adding weights:
0.30(0.13)+0.20(0.1472)+0.50(0.0729 =
0.039+0.0294+0.0365 = 0.1049 = 10.5% (WACC)
4
International Finance
FN5053/6053
EUROMARKETS
LECTURE 11 Part One
EUROMARKETS: DEFINITION
• Euromarkets – is a term used to describe the network of banks
& other financial institutions domiciled in “Europe”,
transacting in foreign currency-denominated financial
instruments.
• Euromarkets can be divided into 2 broad categories.
Eurocurrency Market
• Euromarkets
Eurodollar
Eurosterling
Euroyen etc.
Eurobond Market
Euro -Commercial paper market
Euro -FRN (Floating Rate Notes) market
Euro – straight bond mkt.
6
EUROMARKETS: CONNECTIVITY
• In terms of a venn-diagram  with linkages
UK Domestic
Mkt.
US Domestic
Market
Euro
sterling
Forex Mkt.
Euro
Yen
Euro $ Comm. Paper
Mkt.
Euro $ FRN
Mkt.
Japanese
Domestic
Mkt.
Euro $
bond mkt.
So, the Euromarkets do not operate in isolation but are linked to
the major domestic markets of OECD countries.
7
THE EUROCURRENCY MARKET
• The prefix “Euro” has nothing to do with the
currency euro or with Europe!
• USD deposited in London become Eurodollars.
• USD on deposit in Toronto or Hong Kong are also
Eurodollar deposits.
• Eurodollar deposits can be placed in a foreign bank
or in the foreign branch of a US bank.
• Eurocurrency market consists of all such banks
dubbed as Eurobanks.
•
* Eurobanks accept deposits and make
loans in foreign currencies.
8
THE EUROCURRENCY MARKET
(cont’d)
• One does not buy or sell Eurocurrencies: No buying
and selling of currencies, just lending and
borrowing.
• The Eurocurrency market involves a chain of
deposits and a chain of borrowers and lenders.
• Most Eurocurrency transactions involve
transferring control of deposits from one Eurobank
to another Eurobank (inside or outside Europe)
• The Eurocurrency market operates just like any
other financial market, except for the absence of
regulations on loans made and interest rates
charged.
9
THE EUROCURRENCY MARKETS
(cont’d)
• All Eurocurrency loans are made on a floating-rate
basis at a fixed margin above LIBOR (some basis
points over and above LIBOR).
• The said margin varies from as little as 15 basis
points to as much as > 300 basis points, depending
on the borrower’s perceived riskiness.
• The maturity of a Eurocurrency loan can vary from
roughly 3 to 10 years (8-10 years for prime
borrowers).
• Normally syndicated loans - in which a number of
banks participate (the bank originating the loan
usually manages the syndicate; in some instances
co-managed; syndication fee of 0.25% to 2% of the
loan value imposed).
THE EURODOLLAR
• A Eurodollar is simply a US $ domiciled outside US. Likewise,
a Euroyen is Jap.¥ domiciled outside Japan, e.g. in Europe.
• The way Euromarkets are established, there is very little
regulatory enforcement.
• Since it is US $ traded in London, neither, the Fed. Reserve
nor the Bank of England have jurisdiction. For the Fed, it is an
offshore transaction, while for the bank of England it is an
offshore currency.
• While the Fed would want to influence their dollars, these
“belong” to foreigners and are transacted overseas.
11
THE EUROBOND MARKET
• The Eurobond market is distinctly different from
the Eurocurrency market.
• Eurobonds are bonds sold outside the countries in
whose currencies they are denominated, and these
are issued directly by the final borrowers.
• Banks in the Eurocurrency market (i.e. Eurobanks)
act as intermediaries, to transform Eurocurrency
deposits into long-term claims on final borrowers:
thus, banks place Eurobonds with the final
investors.
12
GENESIS OF EUROMARKETS
• Massive accumulation of USD in Europe (post-war).
• How did Europe end up with this massive amount of US$s?
• Marshall Plan – Post WW II the US undertook to reconstruct
Europe, Massive amounts of USD were spent in Europe. Much
of this currency remained in Europe and didn’t find its way
back to US. USD was acceptable currency in many European
countries.
• Until the late 60’s, London was practically the only “global”
financial center. The dollars were recycled through London
and remained there.
• Petrodollars – The real boost to Euromarkets was the oil
price hike of the early 70’s. The oil price hikes led to a massive
transfer of wealth from the West to the OPEC countries, the
excess funds flowed back to Europe and added to the dollars
already available (note: oil is $ denominated)
13
EUROMARKETS &THE DOLLAR
• How the Euromarkets began  started really by the Soviets
who needed $ for foreign trade and didn’t want to have their $
reserves in New York for fear for being “frozen” (Cold War).
• So, the Soviets realized that there was enough $ in Europe to
meet all their financing needs.
• Hence the first true Eurodollar bank
 “The Moscow
Norodny” began accepting US $ deposits at its London branch
and paid interest based on US interest rates.
• This attracted a lot of deposits, and other banks saw the
potential for creating a market in $ in London and elsewhere
in Europe.
14
THE EXPANSION OF
EUROMARKETS
• With the success of Eurodollars, the large banks saw that they
could use the same concept to create markets in other
“international’ currencies, like DM, SFR and JPY.
• And so, the Eurocurrency Market come to being!
• The real impetus though was the restrictions and
extensive regulations in the US, Germany and
Japan.
15
WHY DO EUROMARKETS EXIST?
• The Eurocurrency market has thrived for one big
reason: government regulation.
• Banks and suppliers of funds are able to avoid
certain regulatory costs and restrictions by going
into the Euromarkets:
•
* No reserve requirements
•
* No special charges/taxes on
transactions
•
* No mandatory lending to preferred
sectors
•
* No interest rate ceilings on
deposits/loans
•
* No rules/regulations restricting16
competition
HOW DO THE EUROMARKETS
WORK?
• In the US, the Fed Reserve had (i) Regulation Q  regulating
interest rate (int. rate ceiling on deposits), until recently,
banks were not allowed to pay interest on checking accounts.
• Additionally (ii) Regulation M  requires banks to set aside a
fraction of their deposits as reserve requirement.
• Likewise, other central banks like the Bundesbank and Bank
of Japan  were even more restrictive.
17
HOW THE EUROMARKETS WORK
(cont’d)
•
•
Banks can ‘create’ value if there could overcome these restrictions.

Euromarkets allow them to do precisely that.
– By being able to pay interest on DD deposits, Eurobanks were able to
attract more funds (circumventing Regulation Q)
– By not being required to set aside reserve requirements, banks could
reduce their cost (circumventing Regulation M)

As is well known, banks can ‘create’ new money or credit.
– As to how many times over “the banking system” can expand credit will
depend on the money multiplier.

– In its simplest form, the multiplier is
Money Multiplier =
I
Prop. of money SS held as reserves + cash
18
HOW THE EUROMARKETS WORK
(cont’d)
• So, the smaller the proportion required to be kept as reserves,
the larger the multiplier: 1/0.04 = 25; 1/0.03 = 33.3
• Which really means that the more money a bank can lend out,
the higher the aggregate returns (reduce cost  reserves don’t
pay interest).
• Also, the other administrative costs associated with
regulations are reduced.
• Furthermore, the Euromarket is largely a “wholesale
market”.
19
HOW THE EUROMARKETS WORK
(cont’d)
 So, why doesn’t credit expand to infinity?
It doesn’t, for several reasons:
1. Banks have to hold some amount of cash to meet
withdrawals.
2. “Sovereign risk” – possible (even if unlikely) intervention
by the authorities of the jurisdictions where the
Eurobanks operate.

3. “Solvency risk” - refusal of central banks to function as
“lenders of last resort”.
20
EUROMARKET COSTS
•
The Euromarket spreads (the margin bet. lending and deposit rates)
are generally much narrower than the spreads in domestic money
markets
 Lending rates ( by banks to borrowers) are lower because
1. Lower cost to banks
no reserve requirements
no FDIC (Fed Dep Ins Corp) pmts
2. Banks don’t have to give preferential loans to certain sectors as
they have to domestically
3. As wholesale markets – most loans are to big COs; low cost of
acquiring information about them (also loans are large in size)
21
EUROMARKET COSTS (cont’d)
• Deposit rates are often higher, since:
– Rates have to be higher to attract Deposits.
– Lower regulatory costs mean banks can compete by offering
higher rates (also no reserve requirement).
– No interest rate ceilings. So, with competition, banks are willing
to pay higher rates.
22
EUROCURRENCY LOANS
•
Eurocurrency* loans are based on floating rates – most common
reference rate is the LIBOR – as they involve large amounts over a
long period.
– This reduces duration constraint  therefore helps banks
manage credit risk better.
– Duration would equal the reset period (usually 6 months).
– At times of high volatility, reset periods can be shorter.
•
Loan Syndication is extensive  helps banks manage credit risk.
– Lead bank managers/organizers earn a fee.
Multicurrency Clauses : increasingly borrowers can take and repay
loans in multiple currencies. Sometimes a borrower can borrow in
Eurodollars and repay in multiple currencies. This can give
borrowers the option to match outflow currency with inflow
currencies.
•
•
*Recall: Eurocurrency is unrelated to euros; nor
is it confined to Europe; USD is the dominant Eurocurrency.
23
EUROCURRENCY LOAN: EXAMPLE
• Sime Darby, a Malaysian company, borrows EUR 250
million euro-denominated Eurocurrency (Euroeuro) – a
syndicated loan led by Credit Suisse and Deutsche Bank with
an up-front syndication fee of 2.0%.
• Net proceeds to Sime Darby: EUR 245 million (after
deducting 0.02 x 250 m)
• Interest rate : LIBOR + 1.75% (7.25%, reset every 6
months) where LIBOR = 5.5%
• The 1st semi-annual debt service payment =
EUR 9,062,500 [(0.0725/2) x 250 m].
• Sime Darby’s effective annual interest rate for the 1st six
month is 7.40% [(9,062,500/245 m) x 2 x 100].
• The annualized cost will change with LIBOR6 every 6 mths.24
EUROBONDS
• Eurobonds are bonds sold outside the
countries whose currencies they are
denominated in.
• Most of the advantages and regulatory
characteristic of Eurocurrency’s apply.
However, there are several differences.
25
EUROBONDS (cont’d)
COMMON FEATURES EUROBONDS
1. Most Eurobonds have sinking fund requirements esp. if
maturity  7 yrs. (Borrower pays sinking fund or fixed
amount to retire the bond  sometimes to a trustee bank).
2. Have call provisions  giving borrower (i.e. issuer) the
option to redeem the bond earlier.
3. Eurobonds are mostly “bearer-form”: i.e. - do not have to
be registered for tax reasons. Whoever holds the bonds
gets repaid. (allows anonymity).  esp. tax evasion.
*This feature is so important that many companies
especially, US Co’s can issue Eurobonds to raise funds
much more cheaply.
4. Whereas Eurocurrency loans are almost always floating
rate loans, Eurobonds come in both the fixed and floating
rate variety.
26
EUROBONDS (cont’d)
• Sinking Fund requires the borrower to retire a fixed
amount of bonds yearly after a specific number of years.
• In the case of Purchase Fund, bonds are retired only if the
market price is below the issue price.
• The purpose of these Funds is to support the market
price of the bonds and to reduce bondholder risk
(ensures that not all the firm’s debt will come due at once).
• Call Provisions give the borrower the option of
redeeming/retiring the bonds before maturity, should
interest rates decline significantly in the future ( Note: Call
Provisions carry a call premium and higher interest rates).
27
EUROBONDS vs.
EUROCURRENCY LOANS
EUROBONDS
EUROCURRENCY LOANS
•
•
•
•
•
•
•
•
Both fixed & floating rates.
Longer maturities (20 years?)
Huge (often billions of $)
Higher floatation costs
(roughly 2.25%).
• Funds must be drawn down in
one sum on a fixed date and
repaid on fixed schedule.
• Switching currency is costly.
• Takes time to raise funds (23months).
Floating rates practically.
Relatively shorter maturities.
Relatively smaller in size.
Lower floatation costs (usually
0.5%).
• Drawdown can be staggered
(fee on used portion) and can
be prepaid in whole or in part
at any time.
• Multicurrency clause.
• Funds raised faster (within 2-3
weeks).
28
EURONOTES
• Euronotes represent a low-cost substitute for
syndicated credits.
• Borrowers issue their own short-term Euronotes
and have them distributed by financial institutions.
• Also known as “Euro-commercial paper”, but the
term Euro-CP is reserved for those Euronotes that
are not underwritten.
• Most Euronotes are USD-denominated with high
face values (often $500,000 or more).
• Euronotes are sold at a discount from face value;
the return to investor is the diff. between purchase
price and face value.
29
EUROMARKET HIGHLIGHTS
• Regulatory Freedom
• Cost Reduction
• Innovation
have been the underlying catalysts for the
development of Euromarkets.
• Since, the early 80’s, the “Asiadollar Market” has
developed: based in Singapore, HK and Tokyo 
(Vietnam War $). Though still small compared to
Eurodollar markets, the Asiadollar market is fast
developing.
• Note: Asiadollar is generically Eurodollar!
30
ASIACURRENCY & ASIABOND
• The Asiadollar market was founded 1n 1968,
located in Singapore, as a satellite market to
channel to and from the Eurodollar market for the
large pool of offshore funds circulating in Asia.
• The Asiabond instrument is called the “dragon
bond”
• Dragon bond is a debt denominated in a foreign
currency (usually dollars), but launched, priced
and traded in Asia.
• The first dragon bond was issued in 1991 by ADB.
• All is not well with dragon bond, as Asian
borrowers with good international credit rating
can raise money more cheaply in Europe or the
United States.
31
FEATURES OF EUROMARKETS
• Major Participants:
*Large commercial and investment banks
*Multinational companies
*International financial organizations
(e.g. IMF).
• Major Centres:
* London
*Paris
*Brussels
*Frankfurt
32
FEATURES OF EUROMARKETS
(cont’d)
• About 75% of Eurobonds have been USDdenominated
• Other currencies featured in Eurobond issues are
EUR, JPY and GBP
• Eurobond market thrives because it remains largely
unregulated and untaxed.
• Big borrowers like Exxon and IBM can raise money
more quickly and more flexibly than they can at
home
• As the interest income is tax free, investors accept
lower interest rates than that on treasury bills
33
FEATURES OF EUROMARKETS
(cont’d)
• The Eurocurrency market and the Eurobond
market exist because they enable borrowers and
lenders to avoid regulations and controls and to
escape payment of some taxes.
• These external markets will survive as long as
governments regulate domestic financial market
but allow free flow of capital.
34
SUMMARY & CONCLUSIONS
• Euromarket is a wholesale market.
• Eurocurrency and Eurobond markets are a response to the
restrictions, regulations and costs that governments impose
on domestic financial transactions.
• Globalization of the financial market has made such govt.
interventions irrelevant (the use of interest rate swap and
currency swap is a case in point)
• Eurobonds have become a viable alternative to Eurocurrency
loans
• Euronotes are short-term papers issued by the borrowers
• Euro-CPs are non-underwritten short-term Euronotes
• Asiacurrency and Asiabond markets are the Asian
counterparts to Euromarket
35
LECTURE 11 (Part Two)
Interest Rate
Derivatives
and
Currency Swaps
36
Interest Rate Swaps
• IRS is an agreement between 2 parties to
exchange USD interest payments for a specific
maturity on a notional amount.
• The notional principal is just a reference
amount for interest calculation (no principal
changes hand).
• Maturities range from <1 year to >15 years
(mostly 2 to 10 years).
• Two types of IRS: (1) coupon swap and (2) basis
swap.
• LIBOR (London Interbank Offered Rate) is the most
important reference rate in swap transactions.
37
Interest Rate Swaps (cont’d)
*Coupon Swap:
one party pays a fixed rate and the other side pays a
floating rate.
*Basis Swap:
Both parties exchange floating interest payments
based on different reference rates
38
Interest Rate Swaps: Example
• Counterparts A and B require $100 million for a five-year
period.
• To reduce uncertainty, A prefers to borrow at fixed rate,
whereas B prefers a floating rate borrowing.
• Suppose: A has difficulty in raising fixed rate bond at
attractive price; but B can borrow at finest rates in either
market.
• For A with BBB rating, the fixed rate available is 8.5%;
floating rate available is 6-month LIBOR + 0.5%.
• For B with AAA rating, the fixed rate available is 7.0%;
floating rate available is 6-month LIBOR.
• A-B fixed rate differential = 1.5% (8.5 – 7.0); A-B floating
rate differential = 0.5%.
• For fixed, the credit quality diff. is worth 150 basis points;
for floating, the credit quality diff. is worth only 50 basis
points.
39
IRS Example (cont’d)
• To begin, A takes out a $100 m five-year floating-rate
Eurodollar loan from a syndicate of banks at an int.
rate of LIBOR + 50 basis pts.
• At the same time, B issues a $100 m five-year
Eurobond with a fixed rate of 7%.
• A and B then enter into an IRS arrangement with GBank.
• A agrees to pay G-Bank 7.35% for five years.
• In return, G-Bank agrees to pay A six-month LIBOR
(LIBOR6) over five years with dates reset to match
the date on its floating-rate loan.
• Thus, A’s floating-rate loan is turned into a fixed-rate
loan @ 7.85% (7.35 + 0.5).
• Note that A saves/gains 65 basis points (8.5 -7.85)!
40
IRS Example (cont’d)
• Similarly, B enters into a swap with G-Bank, agreeing to
pay six-month LIBOR to G-Bank on a notional principal
amount of $100 m for five years in exchange for receiving
payments of 7.25%.
• Thus, B has swapped a fixed-rate for a floating-rate loan at
an effective cost of LIBOR6 minus 25 basis points (7.25 7.0)
• Cost saving for A = 65 basis points; cost saving for B = 25
basis points; what does G-Bank get?
• G-Bank receives LIBOR6 from B and pays LIBOR6 to A
(cancels out)
• G-Bank receives 7.35% from A and pays 7.25% to B,
gaining 10 basis points (7.35 – 7.25), which translates into
$100,000 annually for next five years on the $100 m swap
transaction!
41
Currency Swaps
• A Currency Swap is a transaction in which two
parties agree to exchange a fixed amount of one
currency for another.
• The main difference between an interest rate swap
(IRS) and a currency swap is that, in an IRS,
notional principal is never exchanged. In a
currency swap, however, the notional principal in
two different currencies is exchanged.
• A first exchange of the two currencies occurs at the
initiation of the swap contract. Typically, this first
exchange is based on prevailing spot exchange
rates at the time. This initial exchange is then
reversed at the end of the swap contract period.
Since the amounts exchanged in both periods are
exactly the same, exchange rate risk is eliminated.
42
Currency Swaps (cont’d)
• Technically, a currency swap is an exchange of debt-service
obligations denominated in one currency, for the service on
debt denominated in another currency.
• By swapping future cash flow obligations, the two parties
replace cash flows denominated in one currency with cash
flows in another currency.
• In a dollar/yen swap, an US firm borrowing yen converts its
proceeds into dollars - by swapping its yen obligations for the
dollar obligations of a Japanese counterpart.
• In effect, this is tantamount to the US firm selling fixed
amounts of dollars forward for fixed amounts of yen; or the
Japanese firm selling fixed amounts of yen forward for fixed
amounts of dollars.
Thus, the currency swap contract behaves like a long-dated
forward exchange contract, in which the forward rate is the
current spot rate.
43
Illustration: A Currency Swap
•
Suppose a Malaysian company, MISC, with operations in Japan wishes to expand
its warehousing facilities in Yokohama. The cost of the expansion will be 100
million ¥en. Its banker in Japan, The Bank of Tokyo is willing to provide the financing on the
following terms:
Principal Amount = ¥en 100 million
Loan Tenor
= 5 years
Interest
= fixed 5%; (¥en 5 million) payable annually on 31st Dec.
Principal to be repaid in one lump sum at end of 5th year
•
Now suppose, Matsushita, a Japanese firm with operations in Malaysia wants to
expand its facilities in Malaysia. The estimated cost of the expansion is RM10
million. Matsushita’s banker in Malaysia, Maybank is willing to provide a RM10
million loan on the following terms:
Principal Amount = RM10 million
Loan Tenor
= 5 years
Interest
= fixed 8%; (RM800,000) payable annually on 31st Dec.
Principal to be repaid in one lump sum at end of 5th year
•
If each firm takes the loan being offered without doing anything more, they face
exchange rate risk on both the principal amount and the annual interest payments. If
the currency they borrow in appreciates against their home currency, their effective
cost increases. Additionally, since each firm’s revenues are mostly in their respective
home currency, having a large foreign currency denominated obligation causes a
currency mismatch.
44
Currency Swap (cont’d)
• To avoid these problems, both MISC and Matsushita
could take the foreign currency loans they are being
offered and then enter into a currency swap in order to
overcome the exchange rate risk.
• To see how the swap can be structured, assume that the
spot exchange rate between the ¥en and the Ringgit is 10
¥en per Ringgit. To lock-in the prevailing exchange rate
and avoid currency risk on both the principal and
interest payments over the next 5 years, they can
undertake the swap as follows.
• MISC takes the loan principal of 100 million ¥en from
The Bank of Tokyo and forwards it to Matsushita, which
in turn gives MISC the RM10 million it received from
Maybank. These principal amounts are reversed at the
end of the 5th year. In addition, at the end of each year,
MISC gives Matsushita RM800,000 being 8% interest on
RM10 illion to Matsushita which in turn gives MISC
• ¥en 5 million as (5%) interest on the ¥en loan. Each
company simply passes on the payments received to
their respective banks as fulfillment of their obligation.
45
Mechanics of A Currency Swap
Ringgit / ¥en Currency Swap
Bank of Tokyo
¥en 100 Mil.
MISC
Matsushita
Maybank
Year
¥en 100 Mil.
Year RM 10 Mil.
0
0
RM 10 Mil.
0
1  ¥en 5 Mil.
1
RM800K
¥ 5 Mil
1
RM800K
1
2  ¥en 5 Mil.
2
RM800K
¥ 5 Mil
2
RM800K
2
3  ¥en 5 Mil.
3
RM800K
¥ 5 Mil
3
RM800K
3
4  ¥en 5 Mil.
4
RM800K
¥ 5 Mil
4
RM800K
4
¥en 5 Mil.
5
RM800K
¥ 5 Mil
5
RM800K
5
5
5
¥en 100 Mil.
5
RM 10 Mil.
¥en 100 Mil.
5
0
RM10 Mil.
 5 46
Cost of Currency Swaps
• In the illustration, both parties protect themselves from
exchange rate risk by swapping their home currencies
with no reference to forward rates or future spot rates.
It is in this sense that currency swap is equivalent to a
long-dated forward exchange contract, in which the
forward rate is the current spot rate.
• Note that interest rate in the preceding illustration is 5%
in Japan and 8% in Malaysia. This means that one party
will pay 8% and receive 300 basis points less. This is the
“price” one pays for the currency swap arrangement,
which adjusts to compensate for the differential between
the spot rate and long-term forward rates.
47
Cost of Currency Swaps (cont’d)
• Recall that forward rates are a direct function of the
interest rate differential for the two currencies involved
(interest rate parity theory).
• Therefore, a currency with a lower interest rate has a
correspondingly higher forward exchange value, as is
the case with the yen in the illustration.
• This means that JPY is at a premium and that MYR is at
a discount in the forward market.
• MISC pays 8% interest on behalf of Matsushita, while the
latter pays 5% interest on behalf of MISC – which
suggests a forward spread of 3% in favour of yen.
• Why then currency swap, not forward hedge? The
answer is simple: No forward hedge is available for a
five-year period!
48
Summary & Conclusions
• Interest and currency swaps represent financial
transactions in which 2 counterparties agree to
exchange streams of payments over time - so as to
lower their cost of funds.
• In IRS, no actual principal is exchanged, but
interest payment streams are exchanged.
• “Coupon swaps” refer to swaps from fixed to
floating rate.
• “Basis swaps” refer to swaps from one reference
floating rate to another reference floating rate.
• In currency swaps, notional principal is exchanged
in the beginning and reversed at the end of the
contract.
49
Summary & Conclusions (cont’d)
• Currency swap refers to transaction in which 2
parties exchange specific amounts of 2 currencies at
the outset and repay over time according to a predetermined rule that reflects both interest
payments and amortization of principal.
• Currency swap can help manage both interest rate
and exchange rate risks.
• Currency swap behaves like a long-dated forward
foreign exchange contract, in which the forward
rate is the current spot rate. Interest rate
differential is the implicit forward
premium/discount.
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2011 EXAMINATION QUESTION (5)
(a)“The currency swap contract behaves like a longdated forward foreign exchange contract, in which
the forward rate is the current spot rate”. Explain.
(3 marks)
(a)Illustrate with a hypothetical example how a
currency swap arrangement can work for the
benefit of both parties.
(8 marks)
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END OF LECTURE 11
TAKE CARE!
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