Currency Swaps

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Currency Swaps

Currency Swaps

  1. 1. CURRENCYSWAPS
  2. 2. B.SaiprakashMBA [IM]PondicherryUniversity
  3. 3. An Introduction to Swaps A swap is an agreement between counter-parties toexchange cash flows at specified future times accordingto pre-specified conditions. A swap is equivalent to a coupon-bearing asset plus acoupon-bearing liability. The coupons might be fixed orfloating. A swap is equivalent to a portfolio, or strip, of forwardcontracts--each with a different maturity date, and eachwith the same forward price.
  4. 4. currency swapsA currency swap is a foreign-exchangeagreement between two institute to exchangeaspects (namely the principal and/interestpayments) of a loan in one currency forequivalent aspects of an equal in net presentvalue loan in another currency.A currency swap should be distinguished froma central bank liquidity swap.
  5. 5. Example As a example, suppose the British Petroleum Companyplans to issue five-year bonds worth £100 million at7.5% interest, but actually needs an equivalent amountin dollars, $150 million to finance its new refiningfacility in the U.S. Also, suppose that the Piper Shoe Company, a U. S.company, plans to issue $150 million in bonds at 10%,with a maturity of five years, but it really needs £100million to set up its distribution center in London.
  6. 6. ExampleTo meet each others needs, supposethat both companies go to a swapbank that sets up the followingagreements:
  7. 7. ExampleAgreement 1:1. The British Petroleum Company will issue 5-year£100 million bonds paying 7.5% interest. It will thendeliver the £100 million to the swap bank who willpass it on to the U.S. Piper Company to finance theconstruction of its British distribution center.2. The Piper Company will issue 5-year $150 millionbonds. The Piper Company will then pass the $150million to swap bank that will pass it on to the BritishPetroleum Company who will use the funds tofinance the construction of its U.S. refinery.
  8. 8. ExampleAgreement 2:1. The British company, with its U.S. asset will paythe 10% interest on $150 million to the swap bankwho will pass it on to the American company so itcan pay its U.S. bondholders.2. The American company, with its British asset willpay the 7.5% interest on £100 million to the swapbank who will pass it on to the British company soit can pay its British bondholders.8
  9. 9. ExampleAgreement 3:1. At maturity, the British company will pay $150million to the swap bank who will pass it on to theAmerican company so it can pay its U.S.bondholders.2. At maturity, the American company will pay £100million to the swap bank who will pass it on to theBritish company so it can pay its Britishbondholders.9
  10. 10. Uses of CURRENCYSWAPSCurrency swaps have two main uses:To secure cheaper debt (by borrowing at thebest available rate regardless of currencyand then swapping for debt in desiredcurrency using a back-to-back-loan).To hedge against (reduce exposure to)exchange rate fluctuations
  11. 11. HEDGEInstead of forward contracts, the swap bankalso could hedge its swap position by usinga money market position.For example, on its first sterling liability of£500,000 due in one year, the bank wouldneed to create a sterling asset worth£500,000 one year later and a dollarliability worth $764,524 .
  12. 12. Typical Uses of aCurrency SwapTo convert a liability in one currencyinto a liability in another currency.To convert an investment (asset) inone currency to an investment inanother currency.
  13. 13. Credit Risk: CurrencySwapsNote that there is greater credit risk with acurrency swap when there will be a finalexchange of principal.This means that there is a higherprobability of a large buildup in value,giving one of the counter-parties (the onewho is losing) the incentive to default.
  14. 14. Credit RiskNo credit risk exists when a swap is first created.The credit risk in a swap is greater when there isan exchange of principal amounts at termination.Only the winning party (for whom the swap is anasset) faces credit risk. This risk is the risk thatthe counter-party will default.Many vehicles exist to manage credit risk:Collateral or collateral triggersNetting agreementsCredit derivativesMarking to market

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