30-09-2013, 03:50 PM
Currency Swaps
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Currency Swap: Definition
A currency swap is an exchange of a liability in one currency for a liability in another currency.
Nature:
US corporation with operations in France can obtain comparatively better terms by borrowing dollars, but prefers a loan in euros.
French corporation with operations in the US can obtain comparatively better terms by borrowing euros, but prefers a loan in dollars.
The two companies could go to a swap bank who could arrange for a loan swap.
Example
As 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 (current $/£ rate is $1.50/£), 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.
Valuation
Equivalent Bond Position
Equivalent Bond Position
In the above swap agreement, the American company will receive $15 million each year for five years and a principal of $150 million at maturity and will pay £7.5 million each year for five years and £100 million at maturity.
Equivalent Bond Position
To the American company, this swap agreement is equivalent to a position in two bonds:
A long position in a dollar-denominated, five-year, 10% annual coupon bond with a principal of $150 million and trading at par
A short position in a sterling-denominated, five-year, 7.5% annual coupon bond with a principal of £100 million and trading at par
Equivalent Forward Exchange Position
Instead of viewing its swap as a bond position, the British company could alternatively view its interest agreement to pay $15 million for £7.5 million each year for five years and it principal agreement to pay $150 million for £100 million at maturity as a series of long currency forward contracts in years 1, 2, 3, 4, and 5.
In contrast, the American company could view its swap agreements to sell £7.5million each year for $15 million and sell £100 million at maturity for $150 million as a series of short currency forward contracts.
Summary
The presence of comparative advantage creates a currency swap market in which swap banks look at the borrowing rates offered in different currencies to different borrowers and at the forward exchange rates and money market rates that they can obtain for hedging.
Based on these different rates, they will arrange swaps that provide each borrower with rates better than the ones they can directly obtain and a profit for them that will compensate them for facilitating the deal and assuming the credit risk of each counterparty.