Swaps are zero-sum?

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tx92

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According to the Schweser notes, swaps are a zero-sum game--if one party gains the other loses. But in a currency swap, both parties gain (they both get access to a lower cost of capital). Does Schweser really mean interest rate or equity swaps? Or can currency swaps be seen as zero-sum in the sense that if one of the currencies appreciates, it benefits one party and hurts the other?
 
There is no gain or loss in initiating the swap, but later on depending on exchange rates, one wins some money and the other loses the same sum. So, if A borrows money from B's currency, there is no gain or loss in doing that per se. Same thing for B. He did not gain by simply borrowing from A's country.

But if A's currency appreciates by 5% later on, then B (who holds A's currency) would have a 5% gain, and A (who holds B's currency) would suffer a 5% loss.

That's what I think it means, which is what you stated, I guess.
Guy
 
June: One does gain by simply borrowing. Suppose America Corp can borrow for 9% in the U.S., while Aussie Corp would have to borrow for 10% in the U.S. However, Aussie Corp can borrow for 7% in Australia, and America Corp can borrow for 8% in Australia. This is because both companies are more well known/trusted in their local borrowing markets.

America Corp wants to do business in Australia, while Aussie Corp wants to do business in the U.S. If the exchange rate is 2AUD/USD and the swap amount is 1.0million USD, *Both* companies save 10,000 USD (Aussie Corp) or 20,000 AUD (America Corp) at each interest payment.



Edited 1 time(s). Last edit at Sunday, May 13, 2007 at 05:45PM by tx92.
 
But America Corp could borrow $1 mil dollars locally and exchange them for 2 mil AUD. Aussie corp could borrow 2 Mil AUD locally and exchange them for $1 mill USD to do business in the U.S. How did the swap help?

Guy
 
It's the whole purpose of the currency swap. America Corp is going to be doing business in Australia. If it takes out a $1 million USD loan, exchanges it into AUD, it will be paying interest in USD, exposing it to exchange rate risk because the operations that the loan is paying for will be occurring in Australia.

The best rational options for America corp are to enter into a currency swap or to issue an AUD loan in Australia (where it will receive an unfavorable interest rate). Taking out a USD loan in its local market, and exchanging to AUD exposes the company to too much exchange rate risk.

If this is not so, what is the purpose of a currency swap?

With a currency swap, America Corp takes out a $1million USD loan, and makes a currency swap with Aussia Corp. By entering into a currency swap, both companies save on interest expense, thereby profiting and it's *not* a zero-sum game.

From related CFAI Material, "TGT has effectively issued a dollar-denominated bond and converted it to a euro-denominated bond. In all likelihood, it can save on interest expense by funding its need for euros in this way, because TGT is better known in the United States than in Europe. Its swap dealer, DB, knows TGT well and also obviously has a strong presence in Europe. Thus, DB can pass on its advantage in euro bond markets to TGT."
 
Good point, but I think it should remain a zero-sum game. Any mere financial shuffling of obligations could not in itself be beneficial to all. That is, value does not get created by rearranging financial terms. Granted, it may not be a zero-sum game as far as those two parties are concerened, but overall it has to be a zero-sum game, or else everyone will endlessly engage in rearrangement of finanical terms to keep on making a profit. No?

Guy
 
Zero-sum doesn't mean that both parties can't be benefited; it just means that no wealth is being created. All (?) derivatives are like this. Equities, for example, are not zero-sum because equity investment can create wealth.
 
What about the savings (in interest expense) that America Corp and Aussie Corp realized?
Does't expenses reduced equate to wealth created?
 
All derivatives can provide positive benefits to both parties. That doesn't mean they aren't zero sum. Its just that their opprtunities or utilities are different.
 
The derivative is zero - sum. The only way benefit accrues to both parties is when another financial instrument is introduced, which isn't the same thing.
 
this is a good question tx. i'm still confused. it seems obvious to me that both parties benefit by taking part in this transaction due to their competitive advantage in each market (doesnt this mean that wealth is created?!? or maybe that is your point joey?)

plyon- can you expand what you mean? this seems like a clear cut case. both parties are benefiting without an additional financial instrument (just the swap).
 
They do both benefit from lower interest rates but that doesnt mean the swap isn't a zero sum game. A's losses are paid to B. The swap is a zero sum game.

Kerry.
 
Sorry Nola... I don't see the example you are talking about. The only example I see is where we've introduced the fact that both parties to the swap also want to borrow.

The only transaction that is zero sum is just the swap and only the swap. Nothing more but the swap. OK?

Now... A's gains (losses) will exactly equal B's losses / (gains). That's all there is to it.

This is the definition of zero sum. For every dollar I make, you lose a dollar.

The introduction of the idea that these companies may enter into the swap because of their unique borowing needs/ abilities is immaterial. I know people like to know WHY companies would like to enter into some of these instruments. And that's great. But don't let it confuse you about what's going on. We saw this in another recent post about hedging a short basket of stocks. The poster was all confused basically because he / she assumed that anyone who was shorting stocks wanted prices to go down. Why in the world would they hedge that?

The point is to focus on the swap itself. The swap is zero sum!
 
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