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Mechanics of Currency Swaps

Presented ByHarsh Gupta - 308 Ashwin Mehta - 313 Pratik Mehta - 314 Divpreet Singh - 320

What are they?


A swap that involves the exchange of principal and interest in one currency for the same in another currency is known as a currency swap. It is considered to be a foreign exchange transaction.

These currency swaps may so happen as one party is able to borrow at cheaper rate than the other party 4 different variants of currency swaps are there1. 2. 3. 4. Fixed for Floating currency swap Fixed for Fixed currency swap Floating for Floating currency swap Amortising currency swap

Taking a simple example to explain the concept Firm A Firm B Can borrow Euro @8% fixed or Can borrow Euro @9.2% fixed Cab borrow US$@ floating rate Can borrow US$ @ 1 year of 1 year LIBOR LIBOR Now if Firm B needs fixed rate Euro , it will approach swap dealer provided Firm A needs floating rate US$. The Swap deal would be conducted in different stages STAGE 1 Firm A borrows Euro @8 % interest rate and Firm B borrows US dollar at LIBOR.

STAGE 2 The 2 firms exchange the borrowed currencies with the help of Swap Dealer After the exchange ,Firm A posseses US$ and Firm B Euro STAGE 3 In this stage the interest payments will flow Firm A will pay LIBOR on US dollar that will reach the US dollar market through, first the swap dealer and then through Firm B. Similarly, Firm B will pay fixed rate interest that will flow to the Euro market through the swap dealer and through Firm A. Firm B will pay fixed rate of interest to the swap dealer that will be more than 8% but less than 9.2%, it is 8.6%. The swap dealer will take his own commission say 0.2% and shall pay to the Firm A 8.4% in this case

STAGE 4 The 2 principals are again exchanged between the 2 counter parties. Firm A gets back Euro and repays the lender . Firm B gets back US$ and repays it to the lender.

Euro Debt Market Dollar Debt Market Principal Euro Firm A Swap Dealer

Principal

Euro Firm B Dollar Stage 1 and 2

Dollar

Euro Debt Market Dollar Debt Market 8% Euro 8.4% Firm A LIBOR$ Stage 3 Swap Dealer

LIBOR

Euro 8.6% Firm B

LIBOR$

Euro Debt Market Dollar Debt Market Principal Euro Firm A Dollar Stage 4 Swap Dealer Euro

Principal

Firm B

Dollar

Benefits of the Currency Swap


Taking the previous example , Firm A gets currency of its own choice and Firm B gets the currency of its own choice. Secondly , Cost of borrowing gets reduced, which brings in gains to Firm A as well as to Firm B E.g for Firm A cost of US$ debt in absense of swap LIBOR cost of US$ debt in after swap Interest paid interest received =8.0% + LIBOR 8.4% =LIBOR 0.4 % Similarly for Firm B gain accrued is 9.2% 8.6% = 0.60 %

Thirdly, currency swap can be used as a tool for hedging foreign exchange exposure. Reduction in the foreign risk enables a firm to operate on a larger scale. The firm reaps in turn the economies of scale. Moreover, if the firm is able to hedge its foreign exchange risk through currency swaps , it can enter new markets and can reap further benefits.

types of Currency Swaps

TYPES OF CURRENCY SWAPS

Fixed for Fixed Currency Swap

Floating for Floating Currency Swap

Fixed for Floating Currency Swap

Amortizing Currency Swap

Definition : Fixed for Fixed Currency Swap

An arrangement between two parties (known as counterparties) in which both parties pay a fixed interest rate that they could not otherwise obtain outside of a swap arrangement.

Example :
BORROW FROM GERMAN MARKET BORROW FROM DOLLAR MARKET

GERMAN FIRM

8.50 %

10.50 %

AMERICAN FIRM

9.25 %

10.75 %

STEP 1: BORROW
EURO :- GERMAN MARKET DOLLAR :- DOLLAR MARKET

BORROWS @ 8.50%

BORROWS @ 10.75%

GERMAN FIRM

AMERICAN FIRM

STEP 2: EXCHANGE
EURO :- GERMAN MARKET DOLLAR :- DOLLAR MARKET

EURO GERMAN FIRM DOLLAR SWAP DEALER

EURO AMERICAN FIRM DOLLAR

STEP 3: INTEREST RATE


EURO :- GERMAN MARKET DOLLAR :- DOLLAR MARKET

MORE 0.25%

PAYS BACK @ 10.75%

GERMAN FIRM

SWAP DEALER

AMERICAN FIRM

DOLLAR LOAN @ 10.50%

DOLLAR LOAN @ 10.50%

STEP 3: INTEREST RATE


EURO :- GERMAN MARKET DOLLAR :- DOLLAR MARKET

PAYS BACK @ 8.50%

EURO LOAN @ 8.75% GERMAN FIRM

EURO LOAN @ 8.80% AMERICAN FIRM

SWAP DEALER

EURO :- GERMAN MARKET


DOLLAR :- DOLLAR MARKET

PAYS BACK @ 8.50%

PAYS BACK @ 10.75%

EURO LOAN @ 8.75%

EURO LOAN @ 8.80%

GERMAN FIRM

SWAP DEALER
DOLLAR LOAN @ 10.50%

AMERICAN FIRM

DOLLAR LOAN @ 10.50%

SAVES 0.25%

Which means that German firm uses dollar loan at 10.50% - 0.25% = 10.25%

EURO :- GERMAN MARKET


DOLLAR :- DOLLAR MARKET

PAYS BACK @ 8.50%

PAYS BACK @ 10.75%

EURO LOAN @ 8.75%

EURO LOAN @ 8.80%

GERMAN FIRM

SWAP DEALER
DOLLAR LOAN @ 10.50%

AMERICAN FIRM

DOLLAR LOAN @ 10.50%

SAVES 0.25%

SAVES 0.20%

Which means that German firm uses dollar loan at 10.50% - 0.25% = 10.25%

i.e., 9.25% - 8.80% = 0.45% Net Gain : 0.45% 0.25% = 0.20%

EURO :- GERMAN MARKET


DOLLAR :- DOLLAR MARKET

PAYS BACK @ 8.50%

PAYS BACK @ 10.75%

EURO LOAN @ 8.75%

EURO LOAN @ 8.80%

GERMAN FIRM

SWAP DEALER
DOLLAR LOAN @ 10.50%

AMERICAN FIRM

DOLLAR LOAN @ 10.50%

SAVES 0.25%

SAVES 0.20%

Which means that German firm uses dollar loan at 10.50 - 0.25 = 10.25%

Finally, Both the parties are gainers in fixed for fixed currency swap

i.e., 9.25% - 8.80% = 0.45% Net Gain : 0.45 0.25 = 0.20%

Definition : Fixed for Floating Currency Swap

An arrangement between two parties (counterparties), in which one party pays a fixed rate, while the other pays a floating rate.

Example :
Company A can take out a loan with a one-year term in the U.S. for a fixed rate of 8% and a floating rate of Libor + 1% , but they would prefer a Fixed Rate. On the other hand, Company B can obtain a loan on a one-year term for a fixed rate of 6%, or a floating rate of Libor +3%, consequently, but they'd prefer a Floating Rate. Through an interest rate swap, each party can swap its interest rate with the other to obtain its preferred interestrate

Floating For Floating Currency Swap

Basis swaps are swaps on which both counter parties pay floating rate. Each counter partys interest payment are tied to different floating rate indices. Some of the indices are 3months, 6months LIBOR, T-bill rate, and the US commercial paper rate

A type of swap in which two parties swap variable interest rates based on different money markets.

This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates.
This is a huge market with billions of notional transaction every day. One of the most active markets is the Yen dollar market.

Example: A company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.

Example:
Basis swap in the same currency are swapping dollar Libor for floating commercial paper, Prime Treasure bills or Constant Maturity Treasury rates or even 90 days Dollar Libor for 180 days Dollar Libor.

Amortizing Currency Swaps

An exchange of cash flows, one of which pays a fixed rate of interest and one of which pays a floating rate of interest, and both of which are based on a notional principal amount that decreases. In an amortizing swap, the notional principal decreases periodically because it is tied to an underlying financial instrument with a declining principal balance, such as a mortgage.

Amortizing cross-currency swaps are typically used to hedge a cross-border project-financing loan in which the debt is paid down over a series of years as the project begins to generate cash flow. Principals amortize over the life of the swap.

Example:

A company has an outstanding dollar loan that is being paid off gradually over 3 years. The company would like to swap this dollar liability into a sterling liability.

An exchange of principal at initiation


An annual re-exchange of part of the principal amount

Uses of Currency Swaps

To switch from making interest payments in one currency to another To raise a foreign currency loan at a cheaper rate than normal by using comparative advantage To hedge foreign exchange risk on foreign investments