Page 130 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 9: Swaps

2. Exchange a stream of fixed or floating interest rate payments in their swapped currencies Notes
for the agreed period of the swap, and then
3. Re-exchange the principal amount at maturity at the initial spot exchange rate.

The currency swap provides a mechanism for shifting a loan from one currency to another, or
shifting the currency of an asset. It can be used, for example, to enable a company to borrow in
a currency different from the currency it needs for its operations, and to receive protection from
exchange rate changes with respect to the loan.
A currency swap is an agreement between two parties to exchange a given amount in one
currency for another, and to repay these currencies with interest in the future" (Kester &
Backstrand, 1995). A currency swap is a foreign exchange agreement between two parties to
exchange a given amount of one currency for another and, after a specified period of time, to
give back the original amounts swapped. Currency swaps can be negotiated for a variety of
maturities up to at least 10 years.
Currency swaps contain the right of offset, which gives each party the right to offset any
non-payment of principal or interest with a comparable non-payment. Absent a right of offset,
default by one party would not release the other from making its contractually obligated
payments. Moreover, because a currency swap is not a loan, it does not appear as a liability on
the parties balance sheets.

Example: Company ABC Limited has borrowed 200 million Swiss francs at 6% and
wishes to transform this liability into dollars. At the same time, company XYZ Limited wishes
to convert a $ 100 million obligation bearing 8% interest rate into a Swiss franc liability. Both
companies' obligations have a four-year maturity and are rated AAA. The prevailing spot
exchange rate between the Swiss franc and the US dollar is SF 2.00/ $1.
Considering the matching hedging needs, a mutually satisfactory swap could be arranged in
which ABC agrees to pay 8% dollar interest to XYZ for 4 years plus $ 100 million at maturity, and
XYZ agrees to pay ABC 6% Swiss franc interest for 4 years plus SF 200 million at maturity. This
way, both borrowers have their debt service to their respective lender exactly covered, and
would be left with a payment stream in the currency of their choice.
A currency swap is an exchange of debt-service obligations denominated in one currency for the
service on an agreed upon principal amount of debt denominated in another currency. By
swapping their future cash flow obligations, the counterparties are able to replace cash flows
denominated in one currency with cash flows in a more desired currency. In this way, Company
A, which has borrowed, say, Japanese yen at a fixed interest rate, can transform its yen debt into
a fully hedged dollar liability by exchanging cash flows with counterparty B. The two loans that
comprise the Currency swap have parallel interest and principal repayment schedules. At each
payment date, company A will pay a fixed interest rate in dollars and receive a fixed rate in yen.
The counterparties also exchange principal amounts at the start and the end of the swap
arrangement.
The counterparties to a currency swap will be concerned about their all-in cost- that is, the
effective interest rate on the money they have raised. This interest rate is calculated as the
discount rate that equates the present value of the future interest and principal payments to the
net proceeds received by the issuer.
Currency swaps contain the right of offset, which gives each party the right to offset any
non-payment of principal or interest with a comparable non-payment. Absent a right of offset,
default by one party would not release the other from making its contractually obligated

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