Unit 8 Currency Swaps

Financial Derivatives – DFA 4212

UNIT 8 CURRENCY SWAPS

Unit Structure

8.0 Overview

8.1 Learning Outcomes

8.2 Currency Swaps

8.3 Possible Currency Swaps Scenarios

8.4 Swap Risks

8.5 Summary

8.6 Activities

8.7 References and Readings

8.0 OVERVIEW

This Unit will focus mainly on currency swaps. The rationales will be analysed, and the

currency swap mechanism and its implications are discussed.

8.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following:

1. Describe what a currency swap is.

2. Demonstrate how to hedge exchange rate risk with swaps.

3. Discuss the rationales for exchange rate swaps.

4. Construct a currency swap contract.

Unit 8 1


8.2 CURRENCY SWAPS

A currency swap is an agreement between two counterparties to swap interest

payments denominated in two different currencies at fixed dates in the future and

for a fixed length of time. A currency swap works precisely on the same principle as

the standard interest rate swap (Please refer to example in Unit 7, Section 7.4). Firm 1

may have a comparative advantage in borrowing in sterling, but requires a dollar

loan and, conversely, Firm 2 may wish to borrow in sterling, but has a comparative

advantage in dollar borrowing. In this scenario, each agent borrowing in the market

in which she has a comparative advantage and then the pair participating in a

currency swap will yield gains to each participant. Note that in a currency swap,

however, the principal amount will have to change hands at both the beginning and

end of the contract (as the borrowings will be denominated in different currencies).

Fixed-rate currency swap

Here the counterparties exchange payments governed by the simple differential between,

say, the interest rate on a seven-year $ corporate bond and the interest rate on a seven-

year SFr corporate bond. In a currency swap the two parties initially exchange a principal

amount in one currency for the same amount in another currency at the current spot rate.

Periodic interest payments are then made in the respective currencies, and the principal

amounts are re-exchanged at maturity. It should be noted that currency swaps differ from

interest rate swaps not only in that interest payments are in two different currencies, but

also because the two principals are exchanged

Other currency swaps

If one of the interest rates in a currency swap is variable (e.g. REPO or LIBOR), we

speak of a fixed-floating currency swap, and if two interest rates are variable, we speak

of a floating-floating currency swap.

Unit 8 2


Most swaps happen because of possibility of interest savings. The basic reason for these

interest savings is capital market segmentation which occurs for different reasons:

Name recognition with lenders: a firm may be well-known in its home country

but unknown in a foreign country, or there may be more information available

about certain market participants in some markets then in other markets (e.g. Coca

Cola is better known than a local firm in Malaysia).

Interpretation of information: the same information on a firm may be interpreted

differently by different lenders.

Differences in regulation and taxation: If an investor faces a higher burden of

taxation or regulation, they will ask for a higher return on investment to be

compensated for this higher burden.

8.3 POSSIBLE CURRENCY SWAPS SCENARIOS

There are a number of rationales why firms and institutions engage in currency swaps and

these are briefly discussed below.

Changing the currency base of a Balance Sheet

A fixed-fixed currency swap transforms a loan against a fixed interest rate in one

currency into a loan against a fixed interest rate in another currency.

Example: Take a German firm with a higher credit rating than a British firm. The

German firm can borrow in DM at five per cent and in £ at eight per cent, whereas the

British firm can borrow in DM at 7.5 per cent and in £ at nine per cent. The German firm

can therefore borrow at lower rates; regardless of currency. Let us say that for hedging

reasons, the German firm prefers to borrow £ (e.g. because the German firm has many £

assets), and the British firm prefers to borrow in DM (e.g. because the British firm has

Unit 8 3


many DM assets). There is a swap opportunity because risk premiums on loans in the two

financial markets in different currencies differ. So, the German firm borrows in DM and

the British firm borrows in £, and then they swap.

Cost savings on new financing: Absolute advantage

Suppose a Japanese firm, A, wants to invest in the US. The Japanese firm needs US

dollars with a term to maturity of five years against a fixed interest rate. However, the

Japanese firm is not very well-known in the US dollar market, though it is relatively well-

known in the YEN market. The difference in name recognition is reflected in the interest

rate cost of YEN borrowing (9%) and the interest rate costs of $ borrowing (11%). A US

firm, B, needs YEN financing with a term to maturity of five years against a fixed interest

rate. The US firm is not well-known in the YEN market, but well-known in the $ market.

The difference in name recognition is reflected in the interest rate cost of YEN borrowing

(9.8%) and the interest rate costs of $ borrowing (10.5%).

YEN US $

Japanese firm

9% 11%

US firm 9.8% 10.5%

Table 1

Both companies want to hedge the exchange rate risk with respect to their borrowing and

also benefits from cost savings. Assume the Japanese firm, A, will borrow YEN against

nine per cent. Subsequently, A sells the borrowed YEN in the FX market (absolute

advantage in YEN borrowing) in exchange for $ and invests the $ proceeds in US assets.

The US firm, B, borrows $ against 10.5 per cent (absolute advantage in $ borrowing),

sells the borrowed $ in the FX market in exchange for YEN and invests the YEN

proceeds in YEN assets. A and B also agree to a fixed-fixed currency swap, where A

pays a $ interest rate to B of 10.5 per cent in exchange for a YEN interest rate of 9 per

cent. You can see this in the scheme below.

Unit 8 4


Activity One

Calculate the net position of both firms.

8.4 SWAP RISKS

The main risks in swaps are:

Credit risk is the failure by one of the two swap parties to make contractual

payments. Indeed a major concern for both parties in an interest rate swap is that the

other party will default on its interest payments. A default would not mean that any

principal is lost since the notional principal amount is retained by both parties, but it

could involve losses on the interest side of the swap. This is precisely why an

intermediary, for an appropriate fee, will often guarantee the swap payments should one

party fail to honour its obligations.

Interest rate risk: is the risk that the swap value declines due to interest rate

movements. Take the example of a fixed-floating interest rate swap, where party A

pays fixed-rate interest and receives LIBOR, and party B receives fixed-rate interest

and pays LIBOR. A decline in the short-term interest rate (LIBOR) will result in a

loss to A and a gain to B.

Unit 8 5


Currency risk: namely, the risk that the swap value declines due to a change in the

exchange rate.

8.5 SUMMARY

A currency swap is an agreement between two counterparties to swap interest

payments denominated in two different currencies at fixed dates in the future and

for a fixed length of time.

Here the counterparties exchange payments governed by the simple differential

between, say, the interest rate on a seven-year $ corporate bond and the interest rate

on a seven-year SFr corporate bond.

If one of the interest rates in a currency swap is variable (e.g. REPO or LIBOR), we

speak of a fixed-floating currency swap, and if two interest rates are variable, we

speak of a floating-floating currency swap.

A fixed-fixed currency swap transforms a loan against a fixed interest rate in one

currency into a loan against a fixed interest rate in another currency.

Credit risk is the failure by one of the two swap parties to make contractual

payments.

Interest rate risk: is the risk that the swap value declines due to interest rate

movements.

Unit 8 6


Currency risk: namely, the risk that the swap value declines due to a change in the

exchange rate.

8.6 ACTIVITIES

Activity Two

How can multinational companies utilise a currency swap to reduce borrowing costs?

Activity Three

Refer to Levich (1998), chapter 13. Analyse carefully the currency swap between the

IBM and World Bank and try to understand the rationales and mechanism related to such

swap.

Activity Four

Keane International Inc. Your firm, rated as AAA, is able to raise capital in US dollars at

as floating rate of LIBOR+50 basis points or Canadian dollar at 5.5% flat. However,

Quinn International ltd, with a rating of BBB is only able to receive the capital in US

dollar at fixed rate, LIBOR +100 basis points or a fixed rate of 7%.

Assume that Keane International Inc wants to borrow US dollars at a floating rate of

interest and Quinn International ltd wants to borrow Canadian dollars at a fixed rate of

interest. A financial institution is planning to arrange a swap and requires a 50-basis-point

spread. If the swap is equally attractive to Keane International Inc and Quinn

International Inc, construct a swap and show the rates of interest they will end up paying.

Activity Five

Read the conclusion of the study based on “Why do non-financial firms use currency

swaps? Theory and Evidence”.

Summarise the main findings. You may wish to download the full article at

http://www.bnet.fordham.edu/public/financialgoswami.

Unit 8 7

http://www.bnet.fordham.edu/public/financialgoswami


Why do non-financial firms use Currency Swaps? Theory and Evidence

Gautam Goswani

Graduate School of Business Administration

Fordham University

113 West 60th Street

New York, NY 10023

Tel: (212) 636 6181

Fax: (212) 765 5573

Email: [email protected]

Jouahn Nam

Lubin School of Business Administration

Pace Plaza, Pace University

New York, NY 10038-1502

Tel.: (212) 346 1818

Fax: (212) 346 1573

and

Milind M Shrikhande

The DuPree College of Management

Georgia Institute of Technology

755 Ferst Drive, Atlanta, GA 30332-0520

Tel.: (404) 894 5109

Fax: (404) 894 6030

Email: [email protected]

Conclusion

Non-financial firms are the primary users of currency swaps. The motivation of these

firms for using currency swaps is closely linked with their long-term hedging and

Unit 8 8


financing strategies. Taking into account the possible menu of choices the firm has for

long-term financing we find that the sensitivity of the firm’s cashflows to unexpected

exchange rate changes can explain why they use currency swaps. To test this theoretical

conjecture, we examine data on use of currency swaps by a large sample of non-financial

firms. Our empirical analysis shows that the use of currency swaps together with long-

term debt is a value-maximising alternative for non-financial firms. Mere use of long-

term domestic debt or foreign debt in segmented international capital markets when

bankruptcy due to exchange rate changes is probable, does not provide a value-

maximising financing alternative.

Currency swaps are beneficial, from the

a) hedging motive, as well as from the

b) financing (value maximisation) motive.

Within the model, the currency swap creates a hedge against exchange rate uncertainty,

thus enabling the firm to avoid bankruptcy costs. The hedging motive differentiates the

currency swap alternative from the home-currency debt-financing alternative. Borrowing

home-currency debt creates a mismatch between the currency of cash inflows and the

currency of the home-currency debt. The mismatch exposes the firm to the prospect of

bankruptcy. The expected bankruptcy costs render the home-currency debt financing

alternative inferior to the currency swap alternative. The currency swap is beneficial

based on a financing (value maximisation) motive as well. As compared to the foreign-

currency debt-financing alternative, the currency swap is superior due to the economic

exposure effect.

Our empirical analysis also suggests that long-term exposure to exchange rate changes is

best addressed by the use of currency swaps. Other currency derivative instruments such

as currency forwards, futures, and options are short-term instruments which cannot

achieve the dual objectives of long-term hedging and long-term financing for non-

financial firms.

Unit 8 9


1

8.7 REFERENCES AND READINGS

Hull, J.C. (2009). Options, Futures and Other Derivatives. New Jersey: Prentice Hall,

Seventh edition [ISBN 0135009944], Chapter 7, pp 163.

Levich, R.(1998). International Financial Markets, Prices and Policies. Boston: Irwin

McGraw-Hill [ISBN 0-256-13011-6], Chapter 13.

Buckley, A. (2004). Multinational Finance. New Jersey: Prentice Hall, Chapter 14, pp

259.

Unit 8 10

Documents

Unit 8 Currency Swaps