CURRENCY SWAP

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 technique

Currency swap

DEFINITIONS
A 'Currency Swap' is a contract which commits two counterparties to exchange, over an agreed period, two streams of interest payments in different currencies, and at the end of the period to exchange the corresponding principal amounts at an exchange rate agreed to at the start of the contract

A BIT OF HISTORY
Before 1981 companies were involved in back-toback 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.

CROSS-CURRENCY
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 others debt

EXAMPLE 1
Suppose two firms, A and B, can borrow at the fixed rates of interest as follows: $ 10.0% 12.8% 12.2% 11.0%

Firm A Firm B

AN ABSOLUTE BORROWING ADVANTAGE

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.
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.

Therefore:

These

are the minimum rate in each market could be reached.

EXAMPLE 2
Suppose two firms, A and B, can borrow at the fixed rates of interest as follows: $ 10.0% 12.8% 12.2% 11%

Firm A Firm B

A COMPARATIVE BORROWING ADVANTAGE

Observe:

Firm A can pay full 2.2% less than firm B on the debt denominated in U.S. dollars. Firm B can pay only 1.8% less than firm A on the debt denominated in Euros.
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.

Therefore:

The

total cost of borrowing could be decreased

HOW DOES IT HAPPEN

Firm A may be an American company and known better to American investors and financial institutions. Firm B may be a German company and known better to German or European investors and financial institutions.

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.

SCENARIO 1: DIRECT BORROWING

Firm A borrows at 12.2%. Firm B borrows $ at 12.8%. The combined cost of borrowing for two firms is 12.2+12.8 = 25%.

SCENARIO 1: INITIAL CASH FLOW DIAGRAM

German Bank 30M 12.2% 30M Firm A 30M German Branch U.S. Bank $20M 12.8% $20M Firm B $20M U.S. Subsidiary
16

1999-2003

SCENARIO 2: INDIRECT BORROWING (WITH A

CURRENCY SWAP)
Firm

A borrows $ at 10.0%. Firm B borrows at 11%. Firms swap currencies at the beginning and at the maturity of the contract. Firms pay each others interest payments.

1999-2003

Firm A pays firm B 11% on 30M, 3.3M. Firm B pays firm A 10.0% on $20M, $2M.

17

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 others interest payments.

Firm A pays firm B 12.8% on 30M, 3.3M. 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%.

SCENARIO 2: INITIAL CASH FLOW DIAGRAM

U.S. Bank $20M 10.0% $20M $20M Firm A 30M 30M German Branch $20M U.S. Subsidiary
19

German Bank 30M 11% 30M Firm B

1999-2003

SCENARIO 2: INTEREST FLOW DIAGRAM

U.S. Bank $20M 10.0% $2M $2M Firm A 3.3M 3.3M German Branch $2M U.S. Subsidiary
20

German Bank 30M 11% 3.84M Firm B

1999-2003

SCENARIO 3: FINAL CASH FLOW DIAGRAM

U.S. Bank $20M 10.0% $20M $20M Firm A 30M 30M German Branch $20M U.S. Subsidiary
21

German Bank 30M 11% 30M Firm B

1999-2003

CONCLUSIONS

Currency

swaps provide real benefits to both parties.

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