1 (of 26)

IBUS 302: International Finance

Topic 15-Currency Swaps

Lawrence Schrenk, Instructor.

2 (of 26)

Learning Objectives

1. Describe a currency swap and the motives for using it.▪

2. Calculate the cash flows in a currency swap.

3. Calculate the value of a swap.▪

What is a Swap? Contract between counterparties to exchange

cash flows. Notional Amount Maturity Legs Etc…

3 (of 26)

4 (of 26)

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).

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

5 (of 26)

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.

6 (of 26)

Swap Motivations Lower Costs of Capital Hedge FX Risk

Comments Compare with international bonds. Why not hedge?

7 (of 26)

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.

8 (of 26)

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.

9 (of 26)

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? ▪

10 (of 26)

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…

11 (of 26)

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

12 (of 26)

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

13 (of 26)

Currency Swap Example (cont’d) Assumptions

S($/£) 1.50 Principal $15,000,000 (= £10,000,000) Maturity 3 years Coupon Annual

14 (of 26)

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)

15 (of 26)

Currency Swap Example (cont’d)

Firm US ▪$ £Borrows $15 Gives $15 Gets £10

Gets $1.2/year Gives £1.1/year Gets $15 Gives £10Repays $15 ▪

16 (of 26)

t = 3

t

= 1-

3

t

= 0

Currency Swap Example (cont’d)

Firm US Year CF$ CF£

0 - 15.0 + 10.01 + 1.2 - 1.12 + 1.2 - 1.13 + 16.2 - 11.1

Year 3: 16.2 = 15 + 1.2 and 11.1 = 10 + 1.1

17 (of 26)

‘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

18 (of 26)

£16.2 1.4595$11.1

£1.2 1.0909$1.1

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?

19 (of 26)

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.20 (of 26)

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).

21 (of 26)

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.22 (of 26)

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

23 (of 26)

$ 2 3

1.2 1.2 16.215 01.08 1.08 1.08

B

£ 2 3

1.1 1.1 11.110 01.11 1.11 1.11

B