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Unit 9: Interest Rate and Currency Swaps

is tied to, whether repayment is in dollars, sterling, or marks, etc.). In the case of an asset, the Notes
swap can, in a similar fashion, allow the separation of the investment or credit aspect from the
structure of the asset.
With the swap, the contemporary decision process looks to “assemble” financing. First, identify
the most attractive source of funding, regardless of its currency or interest structure and then
engineer the appropriate swap to create the desired liability structure.
There are five basic components of financing:

Credit The willingness of an investor to take the default risk of a company
Funding The provision of loan funds and the return on those funds
Tenor The repayment schedule
Currency The currency denomination(s) of the repayment

Interest Rate The basis on which loan interest is calculated
9.1.1 Development of Parallel Loans

Parallel loans means of financing investment abroad in the face of exchange control regulations
and are regarded as the forerunners of swaps. In fact, currency swap is regarded as an outgrowth
of the experience with parallel and back-to-back loans. Both of these attained prominence in the
1970s when the British government tried to discourage capital outflows by taxing pound sterling
forex transactions and when their usefulness in maneuvering around comprehensive exchange
controls was demonstrated.

Notes Parallel loans involve at least four parties and usually the parties consist of two
pairs of affiliated companies. The parallel loans commonly consist of a loan by an affiliate
of each company to an affiliate of the other company, with the loans being in different
currencies.

Example: Assume that a parent firm in the Netherlands with a subsidiary in UK wants a
one year pound sterling loan. Also, assume a parent corporation in UK with a subsidiary in
Netherlands wants to take a one year loan in guilders. Each parent company has a higher credit
rating in its home country than its subsidiary has in the country in which it is located.
The situation here is ideal for a parallel loan arrangement. Each parent company could borrow
locally at a favourable interest rate in their capital markets and relend to the other’s subsidiary.
This procedure would allow the two subsidiaries to avoid forex transactions and the cost savings
realised could be allocated to effectively lower each subsidiary’s borrowing cost.
Figure 9.1 shows the example. The solid line depicts the resulting exchange of principals. The
flow of interest payments and the repayments of principal are depicted by the broken lines
(2 and 3).
In this example there is a transfer of the Netherlands guilder between the Netherlands parent
and the Netherlands’ subsidiary of the British parent at inception and a transfer back at the
maturity date of the loan so that the Netherlands parent can repay the loan. Similarly, there is a
transfer of the pound sterling principal from the British parent to the British subsidiary of
Netherlands parent and a transfer back at the maturity date so that the British parent can retire
its loan. During the term of the loans the Netherlands subsidiary of the British parent earns

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