Currency Swaps

Dr. Himanshu Joshi

 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..
 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
 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.
 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.
 World Bank IBM Swap

Word Bank IBM

$ payments to investors Sf payments

Investors in in the bonds

issued by the World Bank Investors in bonds
and denominated in US issued by IBM and
dollars denominated in Sf
 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..
 World Bank IBM Swap
Us Dollar Swap Payments

Word Bank IBM

Swiss Francs Swap Payments

$ payments to investors Sf payments

Investors in in the bonds

issued by the World Bank Investors in bonds
and denominated in US issued by IBM and
dollars denominated in Sf
 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.
 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 $1000 must be made..
 Currency Swaps
Now consider the equivalent amount
of principal in Swiss francs. Given an
assumed time 0 Spot FX rate of 1.6
Sf/$, = Sf1600.
Thus Swiss franc bond makes coupon
payment of 0.04 (Sf1600) = Sf64 per
year.
At the last also repays principal of Sf
1600.
 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..
 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.
 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..
 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 $1
million.
What are the cash flows of the swap
if USD coupon rate is 5.5% and
British pound Coupon rate is 9%.
 Review of Bond Valuation..
Bond Pricing.
YTM
 Off Market Swap
Any two parties can agree at time 0 to
exchange cash flows streams that do not have
the same present value, given the current spot
FX rate.
In this case, the recipient of the cash flow
stream with higher present value must make
some time -0 balancing payment to the party
receiving the cash flow stream with lower
present value.
The time 0 balancing payment would equalize
the present value of the exchnage.
 OFF Market Swap
Q. Assume that the time-0 spot FX rate
is 1.60$/. 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
 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?
 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..
 Back to Back Loans..
Even if companies in different countries do not need new
capital, they can arrange hypothetical loans to each
others 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 Parents US subsidiary books a US dollar
loan on its balance sheet, payable to US parent.
At the same time, the US Parents 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..
 Back to Back Loans..
On balance sheet items.
Increase leverage ratios..
Difficult to link loan legally..
 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..
 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.
 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..
 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%.
 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.
 Swap Driven Financing..
GE wants to raise money in US.
World Bank wants to raise money in
Switzerland.
US Switzerland

GE has to pay 8% on GE has to pay 5%

USD bond. on SF bond.

World Bank has to pay World Bank has to

7% on USD bond. pay 6% on SF bond.
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
7%
US

5%
D

Sf.

World Bank Would Issue USD bonds having

obligation of 7%
Pay 5% Sf to GE
Receive 7% USD form GE.
 Swap Driven Financing..
The 5% incoming Swiss francs from the swap
would cover GEs 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 banks 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.
 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.
 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.
 Synthetic Base Currency
Debt
Company has actual foreign currency
debt
Company has taken long swap
position in foreign currency.
 Synthetic Foreign Currency
Debt
Company has actual base currency
debt.
Company takes short swap position
in foreign currency.
 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.
 Example:

Consider five year fixed-for-fixed

currency swap of 6% US dollars for
4% Swiss francs for a notional
principal of $1000.
X0Sf/$ = 1.6 Sf/$.
Interest on USD loan = .06*$1000=
$60.
In currency swap:
Principal = $1000*1.6Sf/$=Sf1600.
 Difference Check Settlement of
Swap
DSf$ = ZSf * (XN$/Sf C$/Sf)

FX Conversion Rate for Interest

Component
CISf/$ = X0Sf/$ (rSf/r$)

FX Conversion Rate for Principal

Component
CISf/$ = X0Sf/$
 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 /$.
 Mark to Market Value of Currency
Swap Position
Like other financial instruments, currency swap
positions have a mark-to-market value that fluctuates.
A swap positions MTM value fluctuate with changes in
the interest rates in two currencies and spot FX rate.
M$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.
 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.
 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.
X2Sf/$ = 1.6 Sf/$ ?
X2Sf/$ = 1.25 Sf/$
 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/$, and r$ =
rSf = 5%.
 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.
Example: Off Market Swap..
Assume that time-0 spot FX rate is 1.60 $/
. Suppose you want to make the future
payments on a five year, 5.5% coupon, US
dollar par bond, and to receive payments
on a five year, 10% coupon, sterling bond.
Assume that YTM on five year, 10%
coupon sterling bonds in 9%, not 10%.
Would you with long position on Sterling,
pay or receive a time-0 payment, and for
how much?
 Do it Yourself..
Now in the same example, what is
the off-market time-0 swap payment
necessary to be paid to you ( or by
you), if you have the long sterling
position and want a coupon payment
of 8%. All else remain same..
 Currency Swap and FX Equity
Exposure..
S$ = O$ - (L$/V$)
1 (D$/V$)
L$ = net value of all the firms euro-
denominated liabilities, including
both actual euro debt and the one
sided value of the euro currency
swap position.
 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 $1000. assume that the
swap position has no MTM value.
Assume that XYZ has an FX operating exposure
to the euro of 2.
Calculate FX Equity exposure with and without
swap position.
 Managing FX Equity Exposure with
Currency Swap
ABC company has currently V$ =
$5000, D$=$3000, and thus
S$=$2000. assume an FX operating
exposure of 1.60 to the euro. Let us
say that $2000 of the firms debt is
euro debt, and the rest is $-debt.
Determine the notional principal of a
currency swap position that will
eliminate ABCs FX equity exposure.
Assume that euro drops by 10% in FX