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Currency swaps. Definition. A swap is a derivative contract equivalent to a bundle of forward contracts Swaps are designed to take advantage of the Quality Spread Differential - QSD QSD arise whenever there is a comparative advantage situation. Exemplification: Alpine Ski.
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Definition A swap is a derivative contract equivalent to a bundle of forward contracts Swaps are designed to take advantage of the Quality Spread Differential - QSD QSD arise whenever there is a comparative advantage situation
Exemplification: Alpine Ski Alpine Ski Inc. is a Swiss manufacturer of sporting goods. It needs to borrow $2 m to buy supplies and raw material from the United States. Southern Inc. is a U.S. manufacturer of electronic equipment. It needs to borrow SFR 2.8 m to buy electronic components from Switzerland. Southern is relatively unknown in the Swiss market. The two companies decide to use a dealer to enter a foreign currency swap. One-year borrowing rates:
Note Alpine has an absolute advantage at borrowing in either USA or Switzerland because it is better known Alpine has a comparative advantage at borrowing at home Southern has a comparative advantage at borrowing at home
QSD calculation QSD = [8.5% - 7.5%] - [10% - 9.875%] = 0.875% QSD = 87.5 basis points
Splitting the QSD The 87.5 basis points have to be divided among Alpine, Southern, and the dealer. The dealer is quoting the swap, hence it has more power over how the QSD is split
Swiss creditors Alpine US creditors Southern Dealer The onset $2 m at 10% SFR2.8 m at 7.5% SFR2.8 m $2 m SFR2.8 m $2 m
Swiss creditors Alpine US creditors Southern Dealer Interest payments SFR 0.21 m $0.2 m $0.2 m SFR 0.21 m $0.195 m SFR 0.224 m
Swiss creditors Alpine US creditors Southern Dealer Repayment of the principal $2 m SFR2.8 m $2 m SFR2.8 m $2 m SFR2.8 m
Analysis Alpine Ski Inc. borrows $2 m and pays $0.195 m in interest, that is 9.75%. Southern Inc. borrows SFR2.8 m and pays SFR0.224 m in interest, that is 8%.
The dealer Pays: - ($195,000 - $200.000) = $5,000 Receives: (SFR224,000 - SFR210,000) = SFR14,000 As long as e < SFR2.8/$ the dealer makes a net gain
Alpine Southern Dealer Summary Gets 12.5 basis points Gets 50 basis points Gets 25 basis points
Example 2 A US MNC desires to finance a capital expenditure of its German subsidiary. The project has an economic life of five years. The cost of the project is €40,000,000. The German subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years. Assume a German MNC of equivalent creditworthness has a mirror-image financing need. It has a US subsidiary in need of $ 25,000,000 to finance capital expenditure with an economic life of five years. The US subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years.
Example 2 The two MNC face the following possible borrowing rates:
Analysis: For the US MNC subsidiary in Germany the borrowing alternatives are the following: The swap: Cost of borrowing: locked in at 6% Borrowing in Germany: Cost of borrowing locked in at 7% Borrowing in the US: Cost of borrowing variable, depends on exchange rate. If international parity holds it should be 6.025%
Analysis: For the German MNC subsidiary in the US the borrowing alternatives are the following: The swap: Cost of borrowing: locked in at 8% Borrowing in the US: Cost of borrowing locked in at 9% Borrowing in Germany: Cost of borrowing variable, depends on exchange rate. If international parity holds it should be 7.97%
Decision Clearly, entering the swap reduces some of the uncertainty for both companies. In the end, the borrowing decision will depend on how both parties will forecast future exchange rate movements.
