International Finance
Currency Swaps
1
Motivation
Firm A wants to borrow£Firm B wants to borrow $Each has existing receivables
2
Motivation
A is more credit-worthyA has absolute advantage in both $ and £
3
Motivation
A has comparative advantage in dollarsB has comparative advantage in pounds
4
Motivation
Swaps work when each firm wants to borrow in currency where other enjoys a comparative advantage
5
Potential Gain
Potential gain from swapDifference between the differences in borrowing rates
6
Potential Gain
Potential gain from swapCan be divided among firms and intermediary (if used)
7
Potential Gain
Potential gain from swapFirm A 0.6%Firm B 0.6%Intermediary0.4%1.6% = potential gainThe distribution of the potential gain among the three parties is negotiated. This is an example.
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Mechanics of the Swap
Notional principalAmount of money the swapped payments are based onExpressed in both currencies
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Mechanics of the Swap
ExampleFirm A will borrow $15 million from its lenderFirm B will borrow £10 million from its lenderCurrent spot XR is 1.5 $/£Each firm is borrowing same amount of money
10
Mechanics of the Swap
Firm A borrows $15 million at 8.0% from its lenderFirm B borrows £10 million at 12.0% from its lenderFirms A and B give principal to intermediary (usually an investment bank) which passes it through
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Mechanics of the Swap
Firm A pays interest to intermediary on £ at 11.0%Firm B pays interest to intermediary on $ at 9.4%Intermediary gives A 8.0% on $15 million to pay its lenderIntermediary gives B 12.0% on £10 million to pay its lender
12
Results
Firm A borrows £ at 11% instead of 11.6%Firm B borrows $ at 9.4% instead of 10%Intermediary (Investment Bank)Receives 11% on £; 9.4% on $Pays 12% on £ ; 8% on $Net to intermediary of 0.4%
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Diagram of Currency Swap
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Investment Bank
11%£
12%£
12%£
9.4%$
8%$
8%$
0
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