Chapter 20 Currency Swaps and Swaps Markets 20

Chapter 20 Currency Swaps and Swaps Markets 20. 1 20. 2 20. 3 20. 4 20. 5 20. 6 20. 7 20. 8 20. 9 20. 10 Parallel Loans: Necessity Is the Mother of Invention Pros and Cons of Parallel Loans Swaps to the Rescue Swaps as Portfolios of Forward Contracts Currency Swaps Interest Rate Swaps Other Types of Swaps and Swap Combinations Hedging the Swap Bank’s Financial Risk Exposure The Benefits of Swaps to the Multinational Corporation Summary Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -1

Parallel loans provide access to new capital markets F Borrow in your local currency and then trade for the debt of a foreign counterparty F Provides access to new capital markets » Legally circumvents taxes on cross-border currency transactions » Provides foreign-source financing foreign subsidiaries » May lower the firm’s cost of capital Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -2

The swap contract F Problems with parallel loans » The foreign counterparty may have default risk » Parallel loans must be capitalized on the balance sheet » Search costs can be high F The swap alternative: Package the parallel loans into a single legal agreement called the swap contract » Reduces default risk via the “rights of set-off” » Need not be capitalized on the balance sheet » High volume leads to low costs Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -3

Swaps (“I’ll pay yours if you pay mine. ”) F Currency Swap » An agreement to exchange a principal amount of two currencies and, after a pre-arranged length of time, re-exchange the original principal. » Interest payments are also usually swapped during the life of the contract. F Interest Rate Swap » Same as a currency swap, but in a single currency. » A difference check is paid during the life of the swap. » The notional principal is not usually swapped. Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -4

Development of the swaps market F 1981 » Salomon Brothers engineers the first currency swap between the World Bank and IBM F Early 1980 s » Swaps are customized, low-volume, high-margin deals F Late 1980 s and 1990 s » Commercial and investment banks begin to serve as swaps dealers » The swaps market turns into a standardized, highvolume, low-margin business » Volume and liquidity grow Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -5

An example of a currency coupon swap F General Motors (U. S. ) » GM has 2 -year, fixed-rate dollar debt priced at 6. 62% compounded semiannually » GM wants floating rate pound sterling debt F British Petroleum (U. K. ) » BP has 2 -year, floating-rate pound debt with semiannual payments and priced at LIBOR + 40 bps » BP wants fixed rate dollar debt Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -6

Currency coupon swaps Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -7

Currency coupon swaps Indication Pricing Schedule ($/£) Maturity Midrate (in $s) 2 years 6. 12% sa 3 years 6. 46% sa 4 years 6. 59% sa 5 years 6. 64% sa Deduct 5 bps if the bank is paying a fixed rate. Add 5 bps if the bank is receiving a fixed rate. All quotes are against 6 -month LIBOR flat. Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -8

General Motors’s swap cash flows Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -9

General Motors’s net cost of funds F General Motors pays 6. 62% and receives 6. 07% in fixed rate dollar debt for a spread of 55 bps (sa) F General Motors pays LIBOR to the swap bank in pounds sterling F General Motors’s net cost of funds is the pound sterling LIBOR rate plus 55 bps (sa) Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -10

British Petroleum’s swap cash flows Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -11

British Petroleum’s net cost of funds F BP pays LIBOR + 40 bps and receives LIBOR on its pound sterling floating rate notes for a spread of 40 basis points F BP pays 6. 17% to the swap bank in U. S. dollars net cost of funds is $ 6. 17% (sa) plus 40 bps » 6. 57% in bond equivalent yield F BP’s Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -12

The swap bank’s cash flows Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2 e 20 -13