currency swaps bill reese international finance 1
TRANSCRIPT
Currency Swaps
Bill Reese
International Finance
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Learning Objectives
In this unit we will learn: What motivates currency swaps When there is potential gain from a currency
swap How currency swaps are structured The role of the financial intermediary
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Motivation
Firm A wants to borrow £ Firm B wants to borrow $
Each has existing receivables
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Interest Rates Each Firm can Borrow at
Dollars Pounds
A 8.0% 11.6%
B 10.0% 12.0%
Motivation
A is more credit-worthy A has absolute advantage in both $ and £
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Interest Rates Each Firm can Borrow at
Dollars Pounds
A 8.0% 11.6%
B 10.0% 12.0%
Motivation
A has comparative advantage in dollars B has comparative advantage in pounds
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Interest Rates Each Firm can Borrow at
Dollars Pounds
A 8.0% 11.6%
B 10.0% 12.0%
Motivation
Swaps work when each firm wants to borrow in currency where other enjoys a comparative advantage
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Interest Rates Each Firm can Borrow at
Dollars Pounds
A 8.0% 11.6%
B 10.0% 12.0%
Potential Gain
Potential gain from swap Difference between the differences in borrowing
rates
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Potential Gain = 2.0% - 0.4% = 1.6%
Dollars Pounds
A 8.0% 11.6%
B 10.0% 12.0%
Difference 2.0% 0.4%
Potential Gain
Potential gain from swap Can be divided among firms and intermediary (if
used)
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Potential Gain = 2.0% - 0.4% = 1.6%
Dollars Pounds
A 8.0% 11.6%
B 10.0% 12.0%
Difference 2.0% 0.4%
Potential Gain
Potential gain from swap Firm A 0.6% Firm B 0.6% Bank 0.4% 1.6% = potential gain
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Mechanics of the Swap
Notional principal• Amount of money the swapped payments are
based on• Expressed in both currencies
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Mechanics of the Swap
Example Firm A wants to borrow $15 million from its lender Firm B wants to borrow £10 million from its lender Current spot XR is 1.5 $/£
Each firm is borrowing same amount of money
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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 intermediary (bank) which passes it through
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Mechanics of the Swap
Firm A pays interest to bank on £ at 11.0% Firm B pays interest to bank on $ at 9.4% Bank gives A 8.0% on $15 million to pay its
lender Bank gives B 12.0% on £10 million to pay its
lender
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Results
Firm A pays 11% for £ instead of 11.6% Firm B pays 9.4% for dollars instead of 10% Bank
Receives 11% on £; 9.4% on $ Pays 12% on £ ; 8% on $ Net to bank of 0.4%
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Diagram of Currency Swap
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A BBank
11% £
12% £
12% £
9.4% $
8% $
8% $