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Swaps can be used to lower borrowing costs and generate higher investment returns. Swaps can be used to transform floating rate assets into fixed rate assets, and vice versa. Swaps can transform floating rate liabilities into fixed rate liabilities, and vice versa. Swaps can transform the currency behind any asset or liability into a different currency.
Two firms can enter into a plain vanilla swap to exploit their comparative advantages regarding quality spread differentials. For example:
Firm B is a low-rated, risky, firm. It can borrow at a fixed rate of 8%, or at a floating rate of LIBOR + 75bp. Potential counter-party, Firm A, can borrow at a fixed rate of 7%, or at a floating rate of LIBOR +25bp.
Firm B
THE SWAP
Floating at LIBOR
Firm A
Capital Market
Net result: Firm B has borrowed at a fixed rate of 7.85%, and Firm A has borrowed at a floating rate equal to LIBOR - 10bp. Both counter-parties to this swap have lowered their interest expense by swapping.
David Dubofsky and 12-4 Thomas W. Miller, Jr.
7.12% fixed
Firm B
Floating LIBOR
Swap
7.08% fixed
Firm
Floating LIBOR
Dealer
The Swap
LIBOR
The result (with the swap) is that A will be paying 5% fixed. B will be paying LIBOR + 100 bp.
David Dubofsky and 12-6 Thomas W. Miller, Jr.
LIBOR A
The result (with the swap) is that A will be receiving 5% fixed. B will be receiving LIBOR + 100 bp.
David Dubofsky and 12-7 Thomas W. Miller, Jr.
Using a Currency Swap to Hedge Against an increase in the Price of a Foreign Currency
Transform a liability in one currency into a liability in another currency. Transform an expense (cost) in one currency into a another currency.
Before the swap, this U.S. firm loses if the $/ exchange rate rises.
$
David Dubofsky and 12-8 Thomas W. Miller, Jr.
Using a Currency Swap to Hedge Against a Decrease in the Price of a Foreign Currency
Transform an investment in one currency into an asset in another currency. Transform a revenue in one currency into a another currency.
Before the swap, this U.S. firm loses if the $/ exchange rate falls.
David Dubofsky and 12-9 Thomas W. Miller, Jr.
If A wants to borrow , and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.
David Dubofsky and 12-10 Thomas W. Miller, Jr.
A gold producer wants to lock in the price it receives for z oz. of gold each month.
In each of the next M years, the gold producer will agree to pay a floating price and receive a fixed price.