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1 (of 26) IBUS 302: International Finance Topic 15-Currency Swaps Lawrence Schrenk, Instructor.

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Presentation on theme: "1 (of 26) IBUS 302: International Finance Topic 15-Currency Swaps Lawrence Schrenk, Instructor."— Presentation transcript:

1 1 (of 26) IBUS 302: International Finance Topic 15-Currency Swaps Lawrence Schrenk, Instructor.

2 2 (of 26) Learning Objectives 1. Describe a currency swap and the motives for using it.▪ 2. Calculate the cash flows in a currency swap. 3. Calculate the value of a swap.▪

3 What is a Swap? Contract between counterparties to exchange cash flows. Notional Amount Maturity Legs Etc… 3 (of 26)

4 4 (of 26) Types of Swaps Interest Rate Fixed for floating interest rate Currency One currency for another currency Commodity Swaps Equity Swaps NOTE: Distinguish swaps from a ‘swap transaction’ (Chapter 5) and a credit default swap (CDS).

5 Currency Swaps Exchange Cash Flows in Different Currencies Bond Cash Flows Principal Exchanged at Beginning and at End Normally, Fixed Rate Coupon Straight Swap Currency Trade which is Reversed at Later Date Interest Payments Debt Payment Swap 5 (of 26)

6 Uses Conversion from a liability in one currency to a liability in another currency. Conversion from an investment in one currency to an investment in another currency. 6 (of 26)

7 Swap Motivations Lower Costs of Capital Hedge FX Risk Comments Compare with international bonds. Why not hedge? 7 (of 26)

8 Swap Risks Price Risk FX Rates can Change Counterparty Risk Disputes over payments Market Valuation Risk FASB requires all derivatives, including swaps, to be stated at fair market value. 8 (of 26)

9 Currency Swap Example Firm US wants to issues bonds to fund a subsidiary in England. The subsidiary will need its initial capital in pounds, and The subsidiary will generate pounds to pay the interest and principal. 9 (of 26)

10 Currency Swap Example (cont’d) Should Firm US issues the bonds in dollars or pounds? ▪ Pounds Pro: No Currency Risk Con: Higher Cost of Debt Dollars Pro: Lower Cost of Debt Con: Long-Term Currency Risk–could it be hedged? ▪ 10 (of 26)

11 Currency Swap Example (cont’d) Firm US Would like to Issue Pound (£) Bonds But Dollar ($) Borrowing has Lower Cost of Debt Firm UK Would like to Issue Dollar ($) Bonds But Pound (£) Borrowing has Lower Cost of Debt Swap Opportunity… 11 (of 26)

12 Currency Swap Example (cont’d) Solution: The firms ‘swap’ the debt cash flows. Firm US Issues Dollar ($) Bonds This captures the Firm US’s advantage in dollar borrowing. Exchanges All Debt Cash Flows with Firm UK Firm US now has the pound (£) cash flows it wants. Firm UK does the reverse 12 (of 26)

13 Currency Swap Example (cont’d) Loosely Firm US does the dollar borrowing for Firm UK Firm UK services that dollar debt Firm UK does the pound borrowing for Firm US Firm US services that pound debt 13 (of 26)

14 Currency Swap Example (cont’d) Assumptions S($/£) 1.50 Principal$15,000,000 (= £10,000,000) Maturity3 years CouponAnnual 14 (of 26)

15 Currency Swap Example (cont’d) Assumptions Firm US r $ 8% (Coupon = $1,200,000) r £ 13% (Coupon = £1,300,000) Firm UK r $ 14% (Coupon = $2,100,000) r £ 11% (Coupon = £1,100,000) 15 (of 26)

16 Currency Swap Example (cont’d) Firm US ▪ $£$£ Borrows $15 Gives $15Gets £10 Gets $1.2/year Gives £1.1/year Gets $15Gives £10 Repays $15 ▪ 16 (of 26) t = 3 t = 1-3 t = 0

17 Currency Swap Example (cont’d) Firm US Year CF$ CF£ 0- 15.0+ 10.0 1+ 1.2- 1.1 2+ 1.2- 1.1 3+ 16.2- 11.1 Year 3: 16.2 = 15 + 1.2 and 11.1 = 10 + 1.1 17 (of 26)

18 ‘Implicit’ Exchange Rates Principal (at Start) Exchanged at S($/£) = 1.50 Interest Payments Implicit Exchange rate of Principle and Interest (at Maturity) Implicit Exchange rate of 18 (of 26)

19 Is this Fair? Firm UK Borrows Pounds at 11% But Only Pays Dollars at 8% Firm US Borrows Dollars at 8% But Must Pay Pounds at 8% Is this fair to Firm US? 19 (of 26)

20 Interest Rate Parity You cannot forget IRP Interest Rates Are Higher in the UK than US IRP: Pound will Depreciate; Dollar will Appreciate IRP says that FX changes will compensate any differences in interest rates. Firm US appears to be paying more, but it is paying in a currency (£) that is depreciating. Firm US: The higher interest rate is counterbalanced by currency depreciation. 20 (of 26)

21 Comparative Advantage What is a Comparative Advantage? David Ricardo and his Free Trade Argument Chapter 1, Appendix for Details Swaps Interest Rate Gains from a Swap only Require a… Comparative Advantage NOTE: Swaps hedge currency exposure (in addition to any interest rate gains). 21 (of 26)

22 Swap Valuation (cont’d) The Value of a Swap is the value of One Leg (minus) The Other Leg In Algebraic Terms: V $ = B £ x S($/£) – B $ V $ = Value of the Swap (in dollars) B £ = Value of the Pound Bond B $ = Value of the Dollar Bond Note: The currency units cancel to leave dollars. 22 (of 26)

23 Swap Valuation (cont’d) To find the Value of Each Bond Discount the Cash Flows (Just Like in FIN 365). Dollar Bond Value Pound Bond Value 23 (of 26)

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