Hedging strategy: Currency Swaps

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sugar01

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Hi Guys,

In a lay man terms, could someone educate me on currency swaps. Illustrations will be greatly appreciated.
 
It�s not my area of expertise, but from what I recall (LI curriculum)� suppose you have company USA and company UK. Givens:

� Co. USA can borrow in the US at 5% and in UK at 7%
� Co. UK can borrow in the UK at 6% and in the US at 8%
� Co. USA needs GBP 100M to build some crap in UK
� Co. UK needs USD 200M to build whatever in the US
� The exchange rate is 2USD for 1GBP

Here is what they do:
� Co. USA borrows USD 200M from the US bank at 5%
� Co. UK borrows GBP 100M from the UK bank at 6%
� Swap: Co. USA gives Co. UK USD 200M and Co. UK gives Co. USA GBP 100M
� At the end of the swap (say, one year) Co. USA receives from Co. UK USD 216 (200M x 1.08). Then Co. USA repays the US bank USD 210M (200M x 1.05) and realizes a profit of USD 6M.
� Co. UK receives from Co. USA GBP 107M (100M x 1.07). Then Co. UK repays the UK bank GBP106M (100M x 1.06) and makes a profit of GBP 1M

Don�t thank me � I did it for me � to see if I can remember this stuff.
 
Good job Lev. Wish I cared to read your response and comment on it, but I don't really feel like doing that.

Sugar, are you taking L1 in Dec?



Edited 1 time(s). Last edit at Wednesday, July 19, 2006 at 11:32AM by CFAHouston.
 
I don't think anyone cares, Houston, except maybe sugar who asked the question in the first place.



Edited 1 time(s). Last edit at Wednesday, July 19, 2006 at 11:28AM by lev.
 
Thanks Lev, am really grateful.. @ Houston I take the Jun 07 exam... I have to work on a senior thesis that has to do with currency swaps and interest swaps and foreign exchange risk management.
 
Not bad. Helps understand WHY currency swaps are done, something CFA tends to forget about. Go figure.
 
Houston, I know this. I took the test in June.

Level 1 doesn't always explain in enough detail WHY derivatives, such as currency swaps, are traded.
 
Lev, thanks for the explanation. Equity swaps and interest rate swaps were pretty easy for me; currency swaps seem a lot harder. I was glad not to see them on the exam (lucky me).

At first, I thought... why do this, since at the end of the swap, each company is paying the same interest rate to the other company that they would pay to the foreign bank.

Then I realized, each company gets to be the lender as well as the borrower (Polonius would be sad). They borrow at their own low rate and lend at the other guy's high rate, though they expose themselves to exchange rate risk in the meantime.

In Lev's example:
Co US had 5% US borrowing and 7% UK Borrowing
Co UK had 6% UK borrowing and 8% US Borrowing

So if currency rates stay constant the profit for swapping is essentially your partner's high rate minus your own low rate:

US profit ends up being 8% - 5% = 3%
6M USD on 200M USD after 1 year is 3%

UK profit ends up being 7% - 6% = 1%
1M GBP on 100M GBP after 1 year is 1%


Changes in exchange rates mess this nice thing up. Presumably what you need to do is to take the 3% and 1% expected profits and then multiply by the ratio of exchange rates at the start and end of the swap, being very careful, because the answers with the currency ratios inverted and mixed up are certainly given as responses A, B, and C, leaving only "D" for the exam response... ;-)


Geez, it's scary how much I've forgotten since June. I can ressurect it, but I'm disturbed that it's not as tip-of-the-tongue as I thought it would be.
 
What you said is true except for the exchange rate part. The exchange rate risk is not as much an issue in the currency swap because each party is obligated to return to the other party at the end of the swap the money they received at the beginning of the swap (plus some interest). So Co. USA will receive USD 200M (plus interest) regardless of what the exchange rate is at the end of the swap.

If you are a growing US firm that continually invests in UK projects (continually needs GBP), then you are vulnerable to the exchange rate risk. In other words, if you find a need to enter into swap agreement #2 and USD has depreciated against GBP during the year that you�ve been under swap agreement #1, you may be required to put up USD 201M against GBP 100M for your next project.

Otherwise, if project #1 is a one-off thing and you don�t intend to invest in anymore UK projects, there is no exchange rate risk there.



Edited 1 time(s). Last edit at Thursday, July 20, 2006 at 11:45AM by lev.
 
Gee Lev, with results likely coming out next week, I sure hope that there aren't too many other guys that have this down as well as you. ;-)


But I still think there is exchange rate risk. If I am the US company, I will get 200m + interest no matter what (216m in your example), but I will also owe 100m GBP + interest (107m in your example) to the UK company.

If the exchange rate doesn't change from 2.0 USD/GBP, the US company has an extra 2m (= 216m - 107m*2), which can be used to offset the 5% interest it must pay to the US bank.

If the exchange rate rises to 2.1 USD/GBP a year later, then Co US needs to come up with 224.7m USD to pay back Co UK (=107m*2.1), which means they need to find an extra 224.7m - 216m = 8.7m USD to complete their end of the bargain. This, in addition to the 5% they owe to the US bank. If the exchange rate moves up from 2.0 to 2.1 USD/GBP, then the effective interest rate is (5m+8.7m)/200m = 6.85%, after considering the exchange rate.

There is presumably a currency forward arrangement to immunize against this. And if you continually need pounds and have a partner that continually needs dollars, you might be able to go ahead and roll over the debt, I suppose.


I'm happy to be corrected on this... as I said, I find this stuff confusing...
 
I stand corrected - you are absolutely right. I let out of sight the fact that at the end of the swap the US company will need to buy GBP in order to return GBP 100M to the UK firm. If the exchange rate moves against you, you are losing money unless you�ve entered into a forward contract to buy GBP 100M at the beginning of the swap. Great point.
 
Thanks for the confirmation. Having said that, let me assure you that my first comment re: "I hope not too many others have this down as well as you" was intended genuinely, not as sarcasm. I don't think I could even have constructed the currency swap scenario without going back and hitting the books (which are conveniently hidden away behind bottles of liquor ;-) ).
 
cheers to that :-) Good luck on the results - I am sure you passed!
 
Thanks guys, I do appreciate your contribution. Am taking notes and hitting various economics and finance text books. Am actually working with an extreme case for my project. Developing countries whose currencies are in bad shape (very volatile), in most cases, most hedging strategies do not favor these companies (especially Microfinance intuitions) who would like to invest in those countries.

Thanks again :-)
 
Sugar, I used to do international development work in Washington (and Brazil)... that sounds interesting. tell me more about what you're doing... and for whom... You can write to [email protected]. Cheers.
 
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