Currency swaps Definition A swap is a derivative contract equivalent to a bundle of forward...

Currency swapsCurrency swaps

DefinitionDefinition

A swap is a derivative contract equivalent to a bundle of forward contracts

Swaps are designed to take advantage of the Quality Spread Differential - QSD

QSD arise whenever there is a comparative advantage situation

Exemplification: Alpine Ski

Alpine Ski Inc. is a Swiss manufacturer of sporting goods. It needs to borrow $2 m to buy supplies and raw material from the United States.

Southern Inc. is a U.S. manufacturer of electronic equipment. It needs to borrow SFR 2.8 m to buy electronic components from Switzerland.

Southern is relatively unknown in the Swiss market.

The two companies decide to use a dealer to enter a foreign currency swap.

One-year borrowing rates:

Switzerland (SFR) United States ($)

Alpine Ski Inc. 7.5% 9.875%

Southern Inc. 8.5% 10%

Alpine has an absolute advantage at borrowing in either USA or Switzerland because it is better known

Alpine has a comparative advantage at borrowing at home

Southern has a comparative advantage at borrowing at home

QSD calculation

QSD = [8.5% - 7.5%] - [10% - 9.875%] = 0.875%

QSD = 87.5 basis points

Switzerland (SFR) United States ($)

Alpine Ski Inc. 7.5% 9.875%

Southern Inc. 8.5% 10%

Splitting the QSD

The 87.5 basis points have to be divided among Alpine, Southern, and the dealer.

The dealer is quoting the swap, hence it has more power over how the QSD is split

The onset

Swiss creditors US creditors

Dealer

AlpineSouthern

SFR2.8 m

at 7.5%

SFR2.8 m

$2 m at 10%

Interest payments

Dealer

AlpineSouthern

SFR 0.21 m

$0.195 m

$0.2 m

SFR 0.224 m

SFR 0.21 m

Repayment of the principal

Dealer

AlpineSouthern

SFR2.8 m

Analysis

Alpine Ski Inc. borrows $2 m and pays $0.195 m in interest, that is 9.75%.

Southern Inc. borrows SFR2.8 m and pays SFR0.224 m in interest, that is 8%.

The dealer

Pays: - ($195,000 - $200.000) = $5,000

Receives: (SFR224,000 - SFR210,000) = SFR14,000

As long as e < SFR2.8/$ the dealer makes a net gain

Summary

Alpine

Southern

Dealer

Gets 12.5 basis points

Gets 50 basis points

Gets 25 basis points

Example 2Example 2

A US MNC desires to finance a capital expenditure of its German subsidiary. The project has an economic life of five years. The cost of the project is €40,000,000. The German subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.

Assume a German MNC of equivalent creditworthness has a mirror-image financing need. It has a US subsidiary in need of $ 25,000,000 to finance capital expenditure with an economic life of five years. The US subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.

Example 2Example 2

The two MNC face the following possible borrowing rates:

US capital marketborrowing rate

German capital marketborrowing rate

US MNC 8% 7%

German MNC 9% 6%

Borrowing alternativesBorrowing alternatives

today Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cash flow (€) with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow ($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by the swap)

DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57

Exchange rate implied by international parity

DM 1.6 DM 1.57 DM 1.54

DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cash flow (DM) without the swap, if borrowing in the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow ($) without the swap, if borrowing in the US

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow ($), without the swap if borrowing in Germany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

US MNC subsidiary in Germany: Cashflow (DM) with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57

Exchange rate implied by internationalparity

DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

25 m -2 m -2 m -2 m -2 m -27 m

€ 1.6 € 1.2 € 1.2 € 1.2 €1.2 € 1.57

DM 1.6 DM 1.57 DM 1.54

DM 1.51 DM 1.48 DM 1.46

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

25 m -2 m -2 m -2 m -2 m -27 m

€ 1.6 € 1.2 € 1.2 € 1.2 € 1.2 € 1.57

€ 1.6 € 1.57 € 1.54

€ 1.51 € 1.48 € 1.46

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

25 m -2 m -2 m -2 m -2 m -27 m

€ 1.6 € 1.2 € 1.2 € 1.2 € 1.2 € 1.57

€ 1.6 € 1.57 € 1.54

€ 1.51 € 1.48 € 1.46

US MNC subsidiary in Germany: Cash flow (€) without the swap, if borrowing in Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cash flow (€) without the swap, if borrowing in the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

Analysis:Analysis:

For the US MNC subsidiary in Germany the borrowing alternatives are the following:

The swap:

Cost of borrowing: locked in at 6%

Borrowing in Germany:

Cost of borrowing locked in at 7%

Borrowing in the US:

Cost of borrowing variable, depends on exchange rate.

If international parity holds it should be 6.025%

Analysis:Analysis:

For the German MNC subsidiary in the US the borrowing alternatives are the following:

The swap:

Cost of borrowing: locked in at 8%

Borrowing in the US:

Cost of borrowing locked in at 9%

Borrowing in Germany:

Cost of borrowing variable, depends on exchange rate.

If international parity holds it should be 7.97%

DecisionDecision

Clearly, entering the swap reduces some of the uncertainty for both companies.

In the end, the borrowing decision will depend on how both parties will forecast future exchange rate movements.

Currency swaps Definition A swap is a derivative contract equivalent to a bundle of forward...

Documents

swaps - University of Colorado Boulderleeds-faculty.colorado.edu/Moyen/teaching/swaps.pdf · Swaps. What is a Swap? A ... Companies X and Y have been oﬀered the following rates

Swaps Copyright 2014 Diane Scott Docking 1. Learning Objectives Describe an interest rate swap Understand swap terminology Be able to set up a simple

SWAPS - Bauer College of Business · 10/21/2018 1 SWAPS Types and Valuation SWAPS Definition A swap is a contract between two parties to deliver one sum of money against another sum

Currency Swaps 1. Currency Swap: Definition A currency swap is an exchange of a liability in one currency for a liability in another currency. Nature:

Swap Currency & Interest Rate. Currency & Interest Rate Swaps This chapter discusses currency and interest rate swaps, which are relatively new instruments

Dividend Swaps 0 - Home - CFTCeconomicanalysis/documents/file/... · 3 Introduction This paper aggregates regulatory swap repository data for index dividend swaps to explore the magnitude

Part 2 – Exotic swap products Asset swaps Total return swaps Forward swaps

Re: Business Conduct Standards for Security-Based Swap ...compensation for recommending different types of swaps (customized vs. standardized, for example) or for recommending swaps

SWAPS - Bauer College of Business · SWAPS SWAPS: Definition and Types Definition A swap is a contract between two parties to deliver one sum of money against another sum of money

Large Trader Reporting for Physical Commodity Swaps ... · Large Trader Reporting for Physical Commodity Swaps: ... Data Records 18-19 (Swap I) Data Records 20-25 (Swap J) ... 2011

CSOs and SWAPs - UMB · 2009. 3. 17. · CSOs and SWAPs Key concepts used in this report SWAP What defines a SWAP are arrangements making all significant (national and external) funding

Chapter 10 Currency & Interest Rate Swaps. Chapter Outline Types of Swaps Size of the Swap Market The Swap Bank Interest Rate Swaps Currency Swaps

GS SWAP Guide Safety Pin SWAPs

Convexity adjustment for constant maturity swaps … adjustment for constant maturity swaps ... the market started observing non-zero spreads between swap rates of the same ... to

MAC Swap Futures - CME Group- At expiration, all open positions deliver into CME Group Cleared Interest Rate Swaps MAC Swap Futures 2 Highlights • MAC Swap Futures average over $570

Debt for Education Swaps - UNESCO · Working Group for Debt for Education Swaps Daniel Filmus ... Paris Club debt swap clause normally permits, ... 2005 Case Study:

MBF1243 Derivatives L7: Swaps · • A swap provides a means to hedge a stream of risky payments 2. Nature of Swaps • A forward contract can be viewed as a simple example of a swap

Part 45 - Swap Data Recordkeeping and Reporting Requirements · §45.3(e) Allocations - for swaps involving allocations, the initial swap txn between the reporting counterparty and

SWAPS. Definition of SWAP A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These

Investment Product Guide- Interest Rate Swap (IRS) · 2020. 8. 26. · Interest rate swaps – liabilities side Source: Bloomberg Liability Swap: Example showed a conversion of floating