1. Currency Swaps

2. © 1999-2003 1 Overview of the Lecture 1. Definitions 2. Motivation 3. A simple example 4. A real world example

3. 1. Definitions

4. © 1999-2003 3 Presentation There are two main kinds of swaps (currency and interest rate) but many different variations exist. As a whole, the swaps market is by far the largest financial derivative market in the world. Currency swap is a long-term financing/hedging technique. It helps manage both interest and exchange rate risk. It can be viewed as a series of forward contracts.

5. © 1999-2003 4 Currency swap A currency swap is an agreement to exchange principal and fixed interest in one currency for principal and fixed interest in another currency. The initial value of the contract is usual chosen to be zero.

6. © 1999-2003 5 Properties A currency swap gives the parties to the contract the right of offset, that is the right to offset any nonpayment of principal or interest with a comparative nonpayment. A currency swap is not a loan and therefore does not change the liability structure of the parties’ balance sheets. There is an exchange of principal (unlike for interest rate swaps).

7. © 1999-2003 6 A bit of history Before 1981 companies were involved in back-to-back loans where they agreed to borrow in their domestic currency and lend to each other these currencies. The long-term currency swap transactions started in August, 1981. The World Bank issued $290mln in bonds and used the dollar proceeds in currency swaps with IBM for German marks and Swiss francs.

8. 2. Motivation: Cross- currency comparative advantage

9. © 1999-2003 8 Usual conditions for a currency swap In general, currency swap assumes that one counterparty borrows under specific terms and conditions in one currency, while the other counterparty borrows under different terms and conditions in a second currency. The two counterparties exchange the net receipts from their respective issues and agree to service each other’s debt.

10. © 1999-2003 9 Example 1 Suppose two firms, A and B, can borrow at the fixed rates of interest as follows: $ € Firm A10.0%12.2% Firm B12.8%11.0%

11. © 1999-2003 10 An absolute borrowing advantage Observe: –Firm A can pay 2.8% less than firm B on the debt denominated in U.S. dollars. –Firm A must pay 1.2% more than firm B on the debt denominated in euros. Therefore: –Firm A has an absolute advantage in borrowing in the U.S. dollar market. –Firm B has an absolute advantage in borrowing in the euro market. The minimum rate in each market could be reached.

12. © 1999-2003 11 Example 2 Suppose two firms, A and B, can borrow at the fixed rates of interest as follows: $ € Firm A10.0%12.2% Firm B11.0%12.8%

13. © 1999-2003 12 A comparative borrowing advantage Observe: –Firm A can pay full 1.0% less than firm B on the debt denominated in U.S. dollars. –Firm A can pay only 0.6% less than firm B on the debt denominated in euros. Therefore: –Firm A has a comparative advantage in borrowing in the U.S. dollar market. –Firm B has a comparative advantage in borrowing in the euro market. The total cost of borrowing could be decreased.

14. © 1999-2003 13 How does it happen? Firm A may be an American company and/or known better to American investors and financial institutions. Firm B may be a German company and/or known better to German or European investors and financial institutions.

15. 3. A Simple Example

16. © 1999-2003 15 Firms need financing in a foreign currency Suppose firm A wants to borrow €30M to finance its new production line in Germany. Suppose firm B wants to borrow $20M to raise capital for its subsidiary in the U.S.

17. © 1999-2003 16 Scenario 1: direct borrowing Firm A borrows € at 12.2%. Firm B borrows $ at 11.0%. The combined cost of borrowing for two firms is 12.2+11.0 = 23.2%.

18. © 1999-2003 17 Scenario 1: initial cash flow diagram German Bank €30M 12.2% U.S. Bank $20M 11.0% Firm AFirm B German Branch U.S. Subsidiary €30M $20M

19. © 1999-2003 18 Scenario 2: indirect borrowing ( with a currency swap) Firm A borrows $ at 10.0%. Firm B borrows € at 12.8%. Firms swap currencies at the beginning and at the maturity of the contract. Firms pay each other’s interest payments. –Firm A pays firm B 12.8% on €30M, €3.84M. –Firm B pays firm A 10.0% on $20M, $2M. Firm A compensates firm B for borrowing € at 12.8% rather than $ at 11.0%.

20. © 1999-2003 19 Scenario 2: initial cash flow diagram U.S. Bank $20M 10.0% German Bank €30M 12.8% Firm AFirm B German Branch U.S. Subsidiary €30M $20M €30M$20M

21. © 1999-2003 20 Scenario 2: interest flow diagram U.S. Bank $20M 10.0% German Bank €30M 12.8% Firm AFirm B German Branch U.S. Subsidiary €3.84M $2M €3.84M$2M

22. © 1999-2003 21 Scenario 3: final cash flow diagram U.S. Bank $20M 10.0% German Bank €30M 12.8% Firm AFirm B German Branch U.S. Subsidiary €30M $20M €30M$20M

23. 4. A Real World Example: Kodak’s Zero-Coupon Australian Dollar Swap through Merrill Lynch

24. © 1999-2003 23 Kodak’s financial needs It needs at least $75M for 5 years. In the U.S. market it can borrow at 7.5% (50 basis points above U.S. Treasuries). Outside the U.S. it can borrow at 7.35% (35 basis points above U.S. Treasuries).

25. © 1999-2003 24 Merrill Lynch’s market analysis Investor interest in non-dollar issues is much stronger in Europe than in the U.S. Kodak should issue a Eurobond debt dominated in a currency different from the U.S. dollar. Australian zero-coupon issue is selling very well in Europe.

26. © 1999-2003 25 The beginning Kodak issues a A$200M zero-coupon, 5-year Eurobond. Net proceeds to Kodak were A$106M or 53% of A$200M. What is the Kodak’s cost of the Eurobond issue?

27. © 1999-2003 26 What can Kodak do? - alternative 1 Kodak can obtain its desired $75M by converting A$106M at the $/A$ = 0.7059. Kodak is exposed to fluctuations in the value of the Australian dollar against the U.S. dollar.

28. © 1999-2003 27 What can Kodak do? - alternative 2 Kodak enters into a 5-year swap contract with Merrill Lynch. At the beginning of the contract, Kodak swaps A$106M for $75M. Over the life of the contract, Kodak pays 7.35% of $75M ($2,756,250 semiannually) to Merrill Lynch. At the maturity of the contract, Kodak swaps $75M back for A$106M. Kodak’s currency risk exposure is eliminated.

29. © 1999-2003 28 The position of Merrill Lynch The currency risk is fully transferred from Kodak to Merrill Lynch. Is Merrill Lynch happy with that? No. What can Merrill Lynch do? It can enter into a currency swap with a party that is willing to pay $ in exchange for A$.

30. © 1999-2003 29 Merrill Lynch’s currency swap conditions Merrill Lynch enters into a swap contract with an Australian Bank agreeing to make semiannual payments of LIBOR less 40 basis points. The Australian bank cannot swap A$200M. It can only swap A$130M and pay Merrill Lunch 13.39% semiannually. Merrill Lynch still has currency exposure because it is left with A$70M (A$200M- A$130M).

31. © 1999-2003 30 Merrill Lynch’s next step Merrill Lynch exchanges the remaining A$38M (A$106M-A$68M) for $27M in the spot market. Merrill Lynch enters into a forward contract with the Australian bank to exchange $37M for A$70M in five years at the rate $/A$ = 0.5286. Now Merrill Lynch is no longer exposed to currency risk.

32. © 1999-2003 31 Merrill Lynch’s last risk exposure Merrill Lunch is exposed to interest rate risk. Where does this risk come from? From Merrill Lynch’s floating rate obligations on the A$68M for $48M swap with the Australian bank. What can Merrill Lynch do? It can enter into an interest rate swap with a party that is willing to pay a floating rate and receive a fixed rate.

33. © 1999-2003 32 Conclusions Currency swaps provide real benefits to both parties. Currency swaps are beneficial when there exist cross-country barriers to full arbitrage. Currency swaps are useful when long-term capital is needed and the forward foreign exchange markets are not well developed.