8/13/2019 currswaps_46387_49580

1/22

Currency swaps

8/13/2019 currswaps_46387_49580

2/22

DefinitionA swap is a derivative contract equivalent to a bundle offorward contracts

Swaps are designed to take advantage of the QualitySpread Differential- QSD

QSD arise whenever there is a comparativeadvantagesituation

8/13/2019 currswaps_46387_49580

3/22

Exemplification: Alpine SkiAlpine Ski Inc. is a Swiss manufacturer of sporting goods. It needs to borrow $2 m tobuy supplies and raw material from the United States.

Southern Inc. is a U.S. manufacturer of electronic equipment. It needs to borrow SFR2.8 m to buy electronic components from Switzerland.

Southern is relatively unknown in the Swiss market.

The two companies decide to use a dealerto enter a foreign currency swap.

One-year borrowing rates:Switzerland (SFR) United States ($)

Alpine Ski Inc. 7.5% 9.875%Southern Inc. 8.5% 10%

8/13/2019 currswaps_46387_49580

4/22

Note

Alpine has an absolute advantageat borrowing ineither USA or Switzerland because it is better known

Alpine has a comparative advantageat borrowing athome

Southern has a comparative advantageat borrowingat home

8/13/2019 currswaps_46387_49580

5/22

QSD calculation

QSD = [8.5% - 7.5%] - [10% - 9.875%] = 0.875%

QSD = 87.5 basis points

Switzerland (SFR) United States ($)Alpine Ski Inc. 7.5% 9.875%Southern Inc. 8.5% 10%

8/13/2019 currswaps_46387_49580

6/22

Splitting the QSD

The 87.5 basis points have to be divided among Alpine,

Southern, and the dealer.

The dealer is quoting the swap, hence it has morepower over how the QSD is split

8/13/2019 currswaps_46387_49580

7/22

The onset

Swisscreditors US creditors

Dealer

AlpineSouthern

SFR2.8 m

at 7.5%

SFR2.8 m

SFR2.8 m

$2 m at 10%

$2 m

$2 m

8/13/2019 currswaps_46387_49580

8/22

Interest payments

Swisscreditors US creditors

Dealer

AlpineSouthern

SFR 0.21 m

$0.195 m

$0.2 m

$0.2 m

SFR 0.224 m

SFR 0.21 m

8/13/2019 currswaps_46387_49580

9/22

Repayment of the principal

Swisscreditors US creditors

Dealer

AlpineSouthern

SFR2.8 m

SFR2.8 m

SFR2.8 m

$2 m

$2 m

$2 m

8/13/2019 currswaps_46387_49580

10/22

AnalysisAlpine Ski Inc. borrows $2 m and pays $0.195 m ininterest, that is 9.75%.Southern Inc. borrows SFR2.8 m and pays SFR0.224 min interest, that is 8%.

8/13/2019 currswaps_46387_49580

11/22

The dealer

Pays: - ($195,000 - $200.000) = $5,000

Receives: (SFR224,000 - SFR210,000) = SFR14,000

As long as e < SFR2.8/$ the dealer makes a net gain

8/13/2019 currswaps_46387_49580

12/22

Summary

Alpine

Southern

Dealer

Gets 12.5 basis points

Gets 50 basis points

Gets 25 basis points

8/13/2019 currswaps_46387_49580

13/22

Example 2A US MNC desires to finance a capital expenditure of its Germansubsidiary. The project has an economic life of five years. The costof the project is 40,000,000. The German subsidiary would be

expected to earn enough on the project to meet the annual dollardebt service and to repay the principal in five years.

Assume a German MNC of equivalent creditworthness has amirror-image financing need. It has a US subsidiary in need of $

25,000,000 to finance capital expenditure with an economic life offive years. The US subsidiary would be expected to earn enoughon the project to meet the annual dollar debt service and to repaythe principal in five years.

8/13/2019 currswaps_46387_49580

14/22

Example 2

The two MNC face the following possible borrowing rates:

US capital marketborrowing rate

German capital marketborrowing rate

US MNC 8% 7%

German MNC 9% 6%

8/13/2019 currswaps_46387_49580

15/22

Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cash

flow () with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57

Exchange rate implied by international

parity

DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

8/13/2019 currswaps_46387_49580

16/22

Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cashflow (DM) with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

DM 1.6 DM 1.2 DM 1.2 DM 1.2 DM 1.2 DM 1.57

Exchange rate implied by internationalparity

DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

8/13/2019 currswaps_46387_49580

17/22

Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cash

flow () with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

1.6 1.2 1.2 1.2 1.2 1.57

Exchange rate implied by international

parity

DM 1.6 DM 1.57 DM 1.54 DM 1.51 DM 1.48 DM 1.46

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

8/13/2019 currswaps_46387_49580

18/22

Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cashflow () with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

1.6 1.2 1.2 1.2 1.2 1.57

Exchange rate implied by international

parity

1.6 1.57 1.54 1.51 1.48 1.46

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin Germany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow (DM) without the swap, if borrowingin the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing inGermany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

8/13/2019 currswaps_46387_49580

19/22

Borrowing alternativestoday Year1 Year 2 Year 3 Year 4 Year 5

US MNC subsidiary in Germany: Cash

flow () with swap

40 m -2.4 m -2.4 m -2.4 m -2.4 m -42.4 m

German MNC subsidiary in US: Cash flow($) with swap

25 m -2 m -2 m -2 m -2 m -27 m

Contractual exchange rate (implied by theswap)

1.6 1.2 1.2 1.2 1.2 1.57

Exchange rate implied by internationalparity

1.6 1.57 1.54 1.51 1.48 1.46

US MNC subsidiary in Germany: Cashflow () without the swap, if borrowing inGermany

40 m -2.8 m -2.8 m -2.8 m -2.8 m -42.8 m

US MNC subsidiary in Germany: Cashflow () without the swap, if borrowing in

the US

40 m -3.14 m -3.08 m -3.02 m -2.96 m -39.42 m

German MNC subsidiary in US: Cash flow($) without the swap, if borrowing in theUS

25 m -2.25 m -2.25 m -2.25 m -2.25 m -27.25 m

German MNC subsidiary in US: Cash flow($), without the swap if borrowing in

Germany

25 m - 1.53 m -1.56 m -1.59 m - 1.62 m -29.04 m

8/13/2019 currswaps_46387_49580

20/22

Analysis:

For the US MNC subsidiary in Germany the borrowing alternativesare the following:

The swap:

Cost of borrowing: locked in at 6%

Borrowing in Germany:

Cost of borrowing locked in at 7%

Borrowing in the US:

Cost of borrowing variable, depends on exchange rate.

If international parity holds it should be 6.025%

8/13/2019 currswaps_46387_49580

21/22

Analysis:

For the German MNC subsidiary in the US the borrowingalternatives are the following:

The swap:Cost of borrowing: locked in at 8%

Borrowing in the US:

Cost of borrowing locked in at 9%

Borrowing in Germany:

Cost of borrowing variable, depends on exchange rate.

If international parity holds it should be 7.97%

8/13/2019 currswaps_46387_49580

22/22

Decision

Clearly, entering the swap reduces some of the uncertainty for bothcompanies.

In the end, the borrowing decision will depend on how both partieswill forecast future exchange rate movements.