Currency swaps

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# Currency swaps - PowerPoint PPT Presentation

Currency swaps Definition 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

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### Currency swaps

Definition

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:

Note

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

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

Swiss creditors

Alpine

US creditors

Southern

Dealer

The onset

\$2 m at 10%

SFR2.8 m

at 7.5%

SFR2.8 m

\$2 m

SFR2.8 m

\$2 m

Swiss creditors

Alpine

US creditors

Southern

Dealer

Interest payments

SFR 0.21 m

\$0.2 m

\$0.2 m

SFR 0.21 m

\$0.195 m

SFR 0.224 m

Swiss creditors

Alpine

US creditors

Southern

Dealer

Repayment of the principal

\$2 m

SFR2.8 m

\$2 m

SFR2.8 m

\$2 m

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

Alpine

Southern

Dealer

Summary

Gets 12.5 basis points

Gets 50 basis points

Gets 25 basis points

Example 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 2

The two MNC face the following possible borrowing rates:

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:

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%

Decision

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.