Currency Swaps Bill Reese International Finance 1

Learning Objectives In this unit we will learn:  What motivates currency swaps  When there is potential gain from a currency swap  How currency swaps are structured  The role of the financial intermediary 2

Motivation Firm A wants to borrow £ Firm B wants to borrow $  Each has existing receivables 3 Interest Rates Each Firm can Borrow at DollarsPounds A8.0%11.6% B10.0%12.0%

Motivation A is more credit-worthy  A has absolute advantage in both $ and £ 4 Interest Rates Each Firm can Borrow at DollarsPounds A8.0%11.6% B10.0%12.0%

Motivation A has comparative advantage in dollars B has comparative advantage in pounds 5 Interest Rates Each Firm can Borrow at DollarsPounds A8.0%11.6% B10.0%12.0%

Motivation Swaps work when each firm wants to borrow in currency where other enjoys a comparative advantage 6 Interest Rates Each Firm can Borrow at DollarsPounds A8.0%11.6% B10.0%12.0%

Potential Gain Potential gain from swap  Difference between the differences in borrowing rates 7 Potential Gain = 2.0% - 0.4% = 1.6% DollarsPounds A8.0%11.6% B10.0%12.0% Difference2.0%0.4%

Potential Gain Potential gain from swap  Can be divided among firms and intermediary (if used) 8 Potential Gain = 2.0% - 0.4% = 1.6% DollarsPounds A8.0%11.6% B10.0%12.0% Difference2.0%0.4%

Potential Gain Potential gain from swap  Firm A 0.6%  Firm B 0.6%  Intermediary 0.4%  1.6% = potential gain  The distribution of the potential gain among the three parties is negotiated. This is an example. 9

Mechanics of the Swap Notional principal Amount of money the swapped payments are based on Expressed in both currencies 10

Mechanics of the Swap Example  Firm A will borrow $15 million from its lender  Firm B will borrow £10 million from its lender  Current spot XR is 1.5 $/£ Each firm is borrowing same amount of money 11

Mechanics of the Swap Firm A borrows $15 million at 8.0% from its lender Firm B borrows £10 million at 12.0% from its lender Firms A and B give principal to intermediary (usually an investment bank) which passes it through 12

Mechanics of the Swap Firm A pays interest to intermediary on £ at 11.0% Firm B pays interest to intermediary on $ at 9.4% Intermediary gives A 8.0% on $15 million to pay its lender Intermediary gives B 12.0% on £10 million to pay its lender 13

Results Firm A borrows £ at 11% instead of 11.6% Firm B borrows $ at 9.4% instead of 10% Intermediary (Investment Bank)  Receives 11% on £; 9.4% on $  Pays 12% on £ ; 8% on $  Net to intermediary of 0.4% 14

Diagram of Currency Swap 15 A B Investment Bank 11% £ 12% £ 12% £ 9.4% $ 8% $ 8% $