1. Currency Swaps Dr. Himanshu Joshi

2. Currency Swaps A currency swap is a contract to exchange two streams of future cash flows in different currencies. Currency swaps are used to convert debt denominated in one currency into synthetic debt denominated in another currency. Synthetic debt created in this way sometimes allows a segment of the capital market to be tapped that would otherwise not be accessible with debt actually denominated in that currency..

3. Currency Swaps When synthetic debt in a currency is created, we think of it as actual debt in that currency when performing analyses of hedging FX exposure. Currency swap positions are useful in managing FX operating exposure in situations where foreign currency debt does not work. A firm with negative FX operating exposure or a positive operating exposure too high to be managed by foreign currency debt, might use currency swaps in its FX financial hedging strategies…

4. World Bank- IBM Currency Swaps 1982 The world bank wanted to raise additional capital and to denominate the liabilities in Swiss francs because of low interest rates in that currency. The US market, though was more receptive to world bank bonds than the Swiss market, since the World bank had already saturated the Swiss market for its bonds, and US investors regarded world bank bonds as having much less risk than Swiss investors did. But US investors wanted bonds denominated in US dollars.

5. World Bank- IBM Currency Swaps 1982 IBM had financed before by issuing Swiss franc debt, but had since developed the view that the Swiss francs was going to appreciates relative to the US dollar. It wanted to replace its Swiss franc debt with US dollar debt.

6. World Bank IBM Swap $ payments to investorsSf payments Word Bank IBM Investors in in the bonds issued by the World Bank and denominated in US dollars Investors in bonds issued by IBM and denominated in Sf

7. World Bank- IBM Currency Swaps 1982 The currency swap let IBM receive cash flows of Swiss francs from world bank, and the world bank to receive US dollars from IBM. The world bank then could go ahead and borrow from US investors in the favorable US market, planning to use its US dollars receipts from the currency swap to make US dollar bond payments. This way Swiss franc swap payment to IBM represented the net liability for the world bank. Similarly, IBM could use the Swiss francs received from World bank to meet its Swiss franc debt obligation. While its US dollar payments to the world bank represented its new effective liability in US dollars..

8. World Bank IBM Swap $ payments to investorsSf payments Word Bank IBM Investors in in the bonds issued by the World Bank and denominated in US dollars Investors in bonds issued by IBM and denominated in Sf Us Dollar Swap Payments Swiss Francs Swap Payments

9. Fixed for Fixed Currency Swaps In this case, the cash flows are based upon straight, or bullet coupon bonds in two currencies. The swap stipulates time until maturity, the two coupon rates, and the notional principal of the swap.

10. Currency Swaps Consider two five year straight bonds, one denominated in US dollars and the other in Swiss francs, which make annual coupon interest payments, which make annual coupon interest payments, having no other features like call or put. Assume coupon rate on USD bond is 6% P.A., and Swiss Bond is 4% P.A., Assuming Principal of $1000 for the USD bond, the coupon int payment are $60 per year. At maturity, the final principal payment of $1000 must be made..

11. Currency Swaps Now consider the equivalent amount of principal in Swiss francs. Given an assumed time 0 Spot FX rate of 1.6 Sf/$, = Sf1600. Thus Swiss franc bond makes coupon payment of 0.04 (Sf1600) = Sf64 per year. At the last also repays principal of Sf 1600.

12. Currency Swaps Any two counter parties can agree to exchange the cash flows based “notionally” on these two bonds, whether counter party actually own the bond or not. Counter party U would agree to receive from counter party S the Swiss franc cash flow of Sf 64 annually for 5 years, Plus Swiss franc 1600 at maturity.. Counterparty S, would agree to receive the USD cash flows of $60 annually for five years, plus $1000 at maturity..

13. Currency Swaps If : Coupon rate = YTM : at the market swap That is, if 6% is the current market yield on five year bond on USD and 4% is the yield on five year Swiss franc bonds, then the principal of each bond is equal to the PV of its future cash flows. Thus PV of swapped cash flows are equivalent at time 0.

14. Currency Swaps The two parties can simply exchange future cash flows worth Sf 1600 today for future cash flows worth $1000 today, which is fair at the current spot FX rate of 1.60 Sf/$. In an at- market swap, no time-0 payment is necessary, because the PV of underlying bonds are equivalent, given the spot FX rate. Many currency swaps originates as at market swaps..

15. Q.. You enter into a five year fixed for fixed currency swap to receive a cash flow stream in British Pound and to pay cash flow stream in USD. The swap is an at the market swap based on the notional principal of $1 million. What are the cash flows of the swap if USD coupon rate is 5.5% and British pound Coupon rate is 9%. SPOT FX rate=1.50$/£..

16. Review of Bond Valuation.. Bond Pricing. YTM

17. Off Market Swap Any two parties can agree at time 0 to exchange cash flows streams that do not have the same present value, given the current spot FX rate. In this case, the recipient of the cash flow stream with higher present value must make some time - 0 balancing payment to the party receiving the cash flow stream with lower present value. The time 0 balancing payment would equalize the present value of the exchnage.

18. OFF – Market Swap Q. Assume that the time-0 spot FX rate is 1.60$/£. Suppose you want to make the future payments on a five-year, 5.50% coupon, US dollar par bond, and to receive payments on a five year, 10% coupon sterling bond. Assume that YTM on five year, 10% coupon, sterling bond is 9%, not 10%. Would you with the long position on sterling, pay or receive a time-0 payment, and for how much?

19. Off Market Swap Q. Now in the same example, what is the off- market time-0 swap payment necessary to be paid to you (or by you), if you have long sterling position and want a coupon payment of 8% all else the same?

20. Parallel Loans and Back to Back Loans.. Currency swaps evolved from parallel loans, which were devised years ago to get around cross border capital controls. British Company can lend pound to a US subsidiary in Britain.. And vice versa..

21. Back to Back Loans.. Even if companies in different countries do not need new capital, they can arrange hypothetical loans to each other’s subsidiary and thus accomplish the exchange of future cash flow stream. Suppose US subsidiary of a Japanese Parent is generating US dollars, and the Japanese subsidiary of US parent is generating yen. The Japanese Parent’s US subsidiary books a US dollar loan on its balance sheet, payable to US parent. At the same time, the US Parent’s Japanese subsidiary books a yen loan on its balance sheet, payable to Japanese parent, and then make future yen interest and principal payments to the Japanese parent. No Principal amount is actually exchanged.. This type of loan is called a back-to-back loan..

22. Back to Back Loans.. On balance sheet items. Increase leverage ratios.. Difficult to link loan legally..

23. Swaps.. Swaps positions were off balance sheet. No computations in leverage ratios.. The cash flows could legally be viewed as offsetting legs of a single transactions, which solved legal problems..(global banks become swap dealers, no counter party risk of bankruptcy) Structuring the swap contracts as instruments whose periodic exchanges can be settled with one-way difference settlement checks, like forward FX contracts, relived the counterparties from exchange of full amounts of funds at each exchange time. Thus reducing risk of counter party default..

24. Swap Driven Financing.. The difference in credit risk perception of US and European Investors was a prime driver of the IBM- world bank currency swap. European often see a strong international company like IBM as having lower credit risk than a supranational agency like world bank. US investors on the other hand, typically have the opposite perception. US investors might require a company like GE to pay a higher US dollar interest rate than world bank. While Swiss investors might require the world bank to pay higher Swiss franc interest rate than GE.

25. Swap Driven Financing.. If the World Bank prefers Swiss franc liability, while GE prefers a US dollar liability, a currency swap can help each organization overcome these asymmetric market perceptions..

26. Swap Driven Financing.. Assume that GE would have to pay an 8% interest rate on US dollar bonds, while the world bank would have to pay only 7%. Also assume that world bank would have to pay a 6% interest rate on Swiss francs liability, while GE would have to pay only 5%.

27. Swap Driven Financing.. For their preferred liability denominations Without currency swap: GE would pay 8% on US dollar bond; And World Bank would pay 6% on Swiss franc bond. If GE issues Swiss francs bond at 5%, the world bank issues US dollar 7% bond, and later two organizations are engage in currency swaps, each ends up with lower effective financing cost in their preferred currencies.

28. Swap Driven Financing.. GE wants to raise money in US. World Bank wants to raise money in Switzerland. US GE has to pay 8% on USD bond. World Bank has to pay 7% on USD bond. Switzerland GE has to pay 5% on SF bond. World Bank has to pay 6% on SF bond.

29. Swap Driven Financing.. GE will issue Swiss Francs Bonds having Obligation of 5%. Pay 7% USD to World Bank Receive 5% SF from World Bank World Bank Would Issue USD bonds having obligation of 7% Pay 5% Sf to GE Receive 7% USD form GE. 7% USD 5% Sf.

30. Swap Driven Financing.. The 5% incoming Swiss francs from the swap would cover GE’s actual 5% Swiss francs liability, and GE would effectively be paying US dollar interest rate at the rate of 7%, lower than the 8% it would have to pay on actual US dollar bonds. The world bank’s 7% US dollar liability would be covered by the currency swap receipts, and the net effective liability would be 5% Sf, again lower than 6% it would have to pay on actual Swiss franc bonds.

31. Swap Driven Financing.. Although currency swaps often involve no initial exchange of principal amounts, this may occur when two bond issuers enter a swap. When an organization issues securities to raise capital and simultaneously originates a swap as an integral part of the deal, we call the arrangement as swap-driven financing.

32. Swap Driven Financing.. In the GE example, GE issues synthetic US dollar bonds through: (1) an actual issue of Swiss francs bonds, and (2) a long Swiss franc position in currency swap.

33. Synthetic Base Currency Debt Company has actual foreign currency debt Company has taken long swap position in foreign currency.

34. Synthetic Foreign Currency Debt Company has actual base currency debt. Company takes short swap position in foreign currency.

35. Settlement of Swap Components with Difference Check Although, the idea behind a swap is to exchange cash flow streams, the settlement of cash flows is often accomplished by means of difference checks.

36. Example: Consider five year fixed-for-fixed currency swap of 6% US dollars for 4% Swiss francs for a notional principal of $1000. X 0 Sf/$ = 1.6 Sf/$. Interest on USD loan =.06*$1000= $60. In currency swap: Principal = $1000*1.6Sf/$=Sf1600. Interest =Sf1000*.04=Sf64.

37. Difference Check Settlement of Swap D Sf $ = Z Sf * (X N $/Sf – C $/Sf ) FX Conversion Rate for Interest Component C I Sf/$ = X 0 Sf/$ (r Sf /r $ ) FX Conversion Rate for Principal Component C I Sf/$ = X 0 Sf/$

38. Do it Yourself.. Consider a six year fixed-for-fixed currency swap of 5% US dollars for 7% Japanese yen on notional Principal of $1 million. Assume that the Spot FX rate when the swap originates is 140 ¥/$. Find the difference check settlement on the interest component if the spot FX value of the yen depreciates to 160¥/$ at time 1. find the difference check settlement on the principal component at time 6 if the spot FX rate then is 160 ¥/$.

39. Mark to Market Value of Currency Swap Position Like other financial instruments, currency swap positions have a mark-to-market value that fluctuates. A swap position’s MTM value fluctuate with changes in the interest rates in two currencies and spot FX rate. M $ sf = W $ Sf – W $ S We take the present value of the future inflows and subtract the present value of the future outflows, using the spot FX rate to compute the present values in a common currency.

40. Mark to Market Value of Currency Swap Position What would be the MTM value just after the second interest settlement of the long Swiss franc position in a five year, $1000, 6% US dollar and 4% Swiss franc currency swap that originated as an at-market swap when the Spot FX rate was 1.60 Sf/$? We need to know two things at the time immediately after the second interest component: (1) The Spot FX rate and (2) The market yields of both currencies for a horizon equal to the remaining life of swap.

41. Mark to Market Value of Currency Swap Position Let us assume that after the time-2 coupon interest component settlement, the market yields on the three year coupon bonds are 6% in US dollars and 4% in Swiss franc. X 2 Sf/$ = 1.6 Sf/$ ? X 2 Sf/$ = 1.25 Sf/$

42. Do it Yourself (MTM) In the US dollar-Swiss franc example, what is the MTM value of the long Swiss franc swap position after the second interest component payment, if the spot FX rate is 2 Sf/$, and r $ = r Sf = 5%.

43. Off Market Swap.. Any two parties can agree at time 0 to exchange cash flow streams that do not have the same present value, given the current spot FX rate. In this case, the recipient of the cash flow stream with higher present value, must make some time- 0 balancing payment to the party receiving the cash flow stream with lower present value. The time-0 balancing payment would equalize the present value of the exchange. This is called an off-market swap.

44. Example: Off Market Swap.. Assume that time-0 spot FX rate is 1.60 $/£. Suppose you want to make the future payments on a five year, 5.5% coupon, US dollar par bond, and to receive payments on a five year, 10% coupon, sterling bond. Assume that YTM on five year, 10% coupon sterling bonds in 9%, not 10%. Would you with long position on Sterling, pay or receive a time-0 payment, and for how much?

45. Do it Yourself.. Now in the same example, what is the off- market time-0 swap payment necessary to be paid to you ( or by you), if you have the long sterling position and want a coupon payment of 8%. All else remain same..

46. Currency Swap and FX Equity Exposure.. Ę S£ $ = Ę O£ $ - (L £ $ /V $ ) 1 – (D $ /V $ ) L € $ = net value of all the firm’s euro- denominated liabilities, including both actual euro debt and the one sided value of the euro currency swap position.

47. Currency Swap and FX Equity Exposure.. Assume that XYZ company has an intrinsic value of $2000, $200 of actual euro debt, $200 of actual non euro debt, and thus IV of equity is $1600. In addition, assume that it has a naked short currency swap position on Euros with notional principal of $1000. assume that the swap position has no MTM value. Assume that XYZ has an FX operating exposure to the euro of 2. Calculate FX Equity exposure with and without swap position.

48. Managing FX Equity Exposure with Currency Swap ABC company has currently V $ = $5000, D $ =$3000, and thus S $ =$2000. assume an FX operating exposure of 1.60 to the euro. Let us say that $2000 of the firm’s debt is euro debt, and the rest is $-debt. Determine the notional principal of a currency swap position that will eliminate ABC’s FX equity exposure. Assume that euro drops by 10% in FX value. Show how intrinsic value stay at $2000. [Ę O£ $ - (L € $ /V $ )]