What is a swap? A swap is a contract between two counter-parties who agree to exchange a stream of payments over an agreed period of several years.

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1 Currency swaps

2 Wha is a swap? A swap is a conrac beween wo couner-paries who agree o exchange a sream of paymens over an agreed period of several years. Types of swap equiy swaps (or equiy-index-linked swap) commodiy swaps credi swaps

3 Equiy swap One pary pays he reurn on a sock index and he oher pary pays a a benchmark rae of ineres. The cashflows can be in he same currency or differen currencies. Uses as asse allocaion ools A pension fund has is asse porfolio invesed in floaing rae noes based on LIBOR. The manager would like o conver some deb based cashflows ino equiy based receips. Advanage Allow exposure o he equiy marke of anoher counry wihou direcly owning he equiy securiies.

4 Commodiy swap The wo counerparies exchange cash flows based on he price of a commodiy such as oil. One pary pays a fixed price on an underlying quaniy of he commodiy and he oher pays a floaing price usually based on he commodiy s average price over a period. Hedge agains price flucuaions For example an oil producer decides for an agreed lengh of ime o lock ino he fixed price of $20 per barrel wih a financial insiuion. In exchange for receiving a fixed price for he oil he producer agrees o pay he counerpary a floaing rae (linked o an index associaed wih he commodiy price).

5 Credi swaps Two main ypes currency swaps; ineres rae swaps. A credi swap involves an exchange of ineres paymens based on an amoun of principal. In he case of currency swaps here is usually also an exchange of principal amouns a iniiaion and mauriy. Furher classificaion o disinguish he purpose. Liabiliy swaps - exchange of paymens on one deb (liabiliy) for paymen on anoher deb. Asse swaps - exchange a sream of income from one invesmen (asse) for income from an alernaive source.

6 Origins of currency swaps Currency swaps originally were developed by banks in he UK o help large cliens circumven UK exchange conrols in he 1970s. UK companies were required o pay an exchange equalizaion premium when obaining dollar loans from heir banks. How o avoid having o pay his premium? An agreemen would hen be negoiaed whereby The UK organizaion borrowed serling and len i o he US company s UK subsidiary. The US organizaion borrowed dollars and len i o he UK company s US subsidiary. These arrangemens were called back-o-back loans or parallel loans.

7 IBM / World Bank wih Salomon Brohers as inermediary IBM had exising debs in DM and Swiss francs. Due o a depreciaion of he DM and Swiss franc agains he dollar IBM could realize a large foreign exchange gain bu only if i could eliminae is DM and Swiss franc liabiliies and lock in he gain. The World Bank was raising mos of is funds in DM (ineres rae = 12%) and Swiss francs (ineres rae = 8%). I did no borrow in dollars for which he ineres rae cos was abou 17%. Though i waned o lend ou in DM and Swiss francs he bank was concerned ha sauraion in he bond markes could make i difficul o borrow more in hese wo currencies a a favorable rae.

8

9 IBM / World Bank IBM was willing o ake on dollar liabiliies and made dollar paymens o he World Bank since i could generae dollar income from normal rading aciviies. The World Bank could borrow dollars conver hem ino DM and SFr in FX marke and hrough he swap ake on paymen obligaions in DM and SFr. Remark 1. The swap paymens by he World Bank o IBM were scheduled so as o allow IBM o mee is deb obligaions in DM and SFr. 2. IBM and he World Bank had AAA-raings; herefore he counerpary risk was low.

10 Exploiing comparaive advanages A domesic company has comparaive advanage in domesic loan bu i wans o raise foreign capial. The siuaion for a foreign company happens o be reversed. domesic bank domesic principal P d domesic company foreign company lend ou foreign principal P f foreign bank P d = F 0 P f domesic company ener ino a currency swap foreign company Goal: To exploi he comparaive advanages in borrowing raes for boh companies in heir domesic currencies.

11 Cashflows beween he wo currency swap counerparies (assuming no ineremporal defaul) domesic company domesic principal P d (iniiaion) periodic foreign coupon paymens c f P f foreign principal P f (mauriy) foreign company domesic company foreign principal P f (iniiaion) periodic domesic coupon paymens c d P d domesic principal P d (mauriy) foreign company Selemen rules Under he full (limied) wo-way paymen clause he nondefauling counerpary is required (no required) o pay if he final ne amoun is favorable o he defauling pary.

12 Cross currency ransacions The associaed cash flows are denominaed in differen moneary unis he principal amouns are usually exchanged a he originaion and mauriy daes. The exchange rae used can be eiher fixed or floaing a he prevailing rae a he ime of ransacion. The wo ineres raes can be eiher fixed or floaing.

13 Asse currency swaps A Briish company has difficulies o raise capial in Pounds bu here exis US asse fund managers who are willing o buy bonds in US dollars issued by he Briish company. By enering ino a currency swap wih a bank he Briish company can raise he Pounds ha i wans.

14 Iniiaion: US asse funds issue bond in US dollars US 15 millions Briish company Inermediae ineres paymens: Pound 10 millions US 15 millions bank US asse funds coupon paymen o bond holders Briish company ineres paymens in Briish pounds ineres paymens in US dollars bank Mauriy of bond and swap: US asse funds US 15 millions (expiraion of US bond) Briish company US 15 millions Pound 10 millions bank

15 Comparison wih forward conracs Forward exchange conrac involves an agreemen now for he sale or purchase of a quaniy of one currency in exchange for anoher currency a a specified fuure dae. The rae of exchange is he spo adjused for he ineres rae differenial beween he wo currencies over he period of he forward conrac ineres rae pariy relaion. How currency swaps differ from ourigh forward conracs? There is ofen an exchange of principal a iniiaion. Ineres usually is exchanged a regular inervals during he swap period. The regular exchange of ineres means ha he re-exchange of principal a mauriy can be a oday s spo rae. The period of a swap is longer han ha for mos forward conracs.

16 Primary funcions of currency swaps Swaps are no a mehod of borrowing money bu raher a means of managing deb and funding requiremens. Creae cheaper funds/deb: a swap can reduce he overall cos of borrowing (liabiliy swap). Improve income from invesmens (asse swap). Hedge longer-erm currency exposures and reduce an organizaion s financial risk.

17 Arranging finance in differen currencies The company issuing he bonds can use a currency swap o issue deb in one currency and hen swap he proceeds ino he currency i desires. Three specific purposes To obain lower cos funds. Suppose here is a srong demand for invesmens in currency A a company seeking o borrow in currency B could issue bonds in currency A a a low rae of ineres and swap hem ino he desired currency B. To gain access o a resriced capial marke. To obain funding in a form no oherwise available. Marke condiions migh preclude he issuance of long erm deb bearing a fixed ineres rae in Yen.

18 Hedging currency exposures Long erm invesmen (liabiliy) in a currency ha generaes (pays) a sream of cashflows exposure o a fall (rise) in he value of he currency. To gain access o a resriced capial marke. To obain funding in a form no oherwise available. Marke condiions migh preclude he issuance of long erm deb bearing a fixed ineres rae in Yen. Locking in a forward rae Currency swaps can be used o lock in a forward rae for a fuure foreign currency receip or paymen eiher as an alernaive o a forward exchange conrac or when a forward conrac is unobainable.

19 Pricing issues of currency swaps

20 Quoing prices Example The following raes are quoed for 3-year cross currency ineres rae swap agains he dollar. Canadian dollars Serling % (dealing spread of 25 bps) % (dealing spread of 20 bps) The quoed raes are he fixed raes ha he bank will pay (lower rae) or receive (higher rae) in a cross-currency ineres rae swap where he counerpary will receive or pay ineres a 6-monh dollar LIBOR.

21 Quoing prices for differen mauriies Example Fixed rae serling agains 6-monh dollar LIBOR Term (years) pay rae receive rae % 8.40% % 8.85% % 9.15% % 9.50% Wih longer mauriy he dealing spread is wider.

22 Represenaive quoes for plain vanilla currency swaps bases on 6-monh U.S. Dollar LIBOR for differen mauriies Currency 2-year 3-year 4-year Yen 3.27% 3.78% 4.12% Serling 8.13% 8.55% 8.65% Swiss franc 5.07% 5.24% 5.38% Deuschemark 6.43% 6.92% 8.08% U.S. dollars 7.79% 7.97% 8.08% The las row conains quoes for plain vanilla US dollar ineres rae swaps for comparison.

23 Pricing of currency swaps The swap raes are se such ha he value of currency swap a iniiaion is zero. The swap value a a fuure dae depends on he ineres raes in he wo currencies r d and r f and he foreign exchange rae F. X k 1 X X k k 2 3 X k n iniial dae value dae n X X j2 j3 j 1 X X j n The paymen daes for he swap cash flows are 1 2 n.

24 Le V j be he swap value in currency j a ime is he discoun facor a ime for mauriy i in currency h h = j k. i h B F j k is he spo exchange rae he price in erms of currency j of currency k a ime. [ ] [ ] n n n n j j j j j j k j k k k k k k j B X B X B X F B X B X B X V = L L The valuaion involves discouning he fuure cash flow sreams in he wo currencies.

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