CURRENCY SWAPS

An Introduction to Swaps

A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions.

A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating.

A swap is equivalent to a portfolio, or strip, of forward contracts--each with a different maturity date, and each with the same forward price.

currency swaps

A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely the principal and/interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.

A currency swap should be distinguished from a central bank liquidity swap.

ExampleAs a example, suppose the British Petroleum

Company plans to issue five-year bonds worth £100 million at 7.5% interest, but actually needs an equivalent amount in dollars, $150 million to finance its new refining facility in the U.S.

Also, suppose that the Piper Shoe Company, a U. S. company, plans to issue $150 million in bonds at 10%, with a maturity of five years, but it really needs £100 million to set up its distribution center in London.

ExampleTo meet each other's needs, suppose that

both companies go to a swap bank that sets up the following agreements:

ExampleAgreement 1: 1.The British Petroleum Company will issue 5-year

£100 million bonds paying 7.5% interest. It will then deliver the £100 million to the swap bank who will pass it on to the U.S. Piper Company to finance the construction of its British distribution center.

2.The Piper Company will issue 5-year $150 million bonds. The Piper Company will then pass the $150 million to swap bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its U.S. refinery.

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Agreement 2: 1.The British company, with its U.S. asset will

pay the 10% interest on $150 million to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders.

2.The American company, with its British asset will pay the 7.5% interest on £100 million to the swap bank who will pass it on to the British company so it can pay its British bondholders.

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Agreement 3: 1.At maturity, the British company will pay

$150 million to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders.

2.At maturity, the American company will pay £100 million to the swap bank who will pass it on to the British company so it can pay its British bondholders.

Uses of CURRENCY SWAPS

Currency swaps have two main uses:

To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).

To hedge against (reduce exposure to) exchange rate fluctuations

HEDGE

Instead of forward contracts, the swap bank also could hedge its swap position by using a money market position.

For example, on its first sterling liability of £500,000 due in one year, the bank would need to create a sterling asset worth £500,000 one year later and a dollar liability worth $764,524 .

Typical uses of a Currency SwapTo convert a liability in one currency into a

liability in another currency.

To convert an investment (asset) in one currency to an investment in another currency.

Credit Risk: Currency Swaps

Note that there is greater credit risk with a currency swap when there will be a final exchange of principal.

This means that there is a higher probability of a large buildup in value, giving one of the counter-parties (the one who is losing) the incentive to default.

Credit RiskNo credit risk exists when a swap is first created.The credit risk in a swap is greater when there is

an exchange of principal amounts at termination.Only the winning party (for whom the swap is an

asset) faces credit risk. This risk is the risk that the counter-party will default.

Many vehicles exist to manage credit risk:Collateral or collateral triggersNetting agreementsCredit derivativesMarking to market