CFM13430 - Understanding corporate finance: derivative contracts: currency swap: example
Currency swap: example
Yondruther plc has made a loan of $100 million to its subsidiary, Yondruther US Holdings Ltd, in order to finance the purchase of a US company. The loan still has 5 years to run. It is at a fixed rate of interest of 5.5%, payable 6-monthly.
The exchange rate is currently $1.6015/£. But the company expects the dollar to depreciate against sterling, so by the time the $100 million is repaid, it will be worth less in sterling terms.
The company could in theory hedge this risk by entering into a forward contract to sell $100 million in 5 years’ time at an agreed rate. But it is unlikely to obtain a forward contract to hedge such a long-term exposure. Moreover, if the dollar depreciates, the sterling value of the interest receipts will also fall. A forward sale of currency would do nothing to mitigate this risk.
Therefore. the company decides to enter into a 5-year dollar/sterling currency swap with a bank, with the following results.
| Over the life of the swap | At the end of the swap |
|---|---|
| Yondruther plc will pay amounts equivalent to US dollar interest to the bank. The bank will pay the company amounts equivalent to sterling interest. |
Yondruther plc will sell $100 million to the bank for sterling, at an agreed exchange rate. Typically, the rate will be something close to the spot rate at the beginning of the swap - it may not be exactly the same. In this example, Yondruther plc agrees an exchange rate of $1.6/£1. So it knows that, in 5 years’ time, it will receive exactly £62.5 million - it has no further exposure to exchange fluctuations. The company is called the payer of the US dollar sum; the bank is the dollar receiver. |
The company and the bank will agree interest rates for the swap. In the simplest form of currency swap, both parties pay a fixed interest rate. Alternatively, they may exchange a fixed rate in one currency for a floating rate in the other currency (a cross-currency interest swap) or a floating rate in one currency for a floating rate in the other (a currency basis swap).
Suppose, in this example, Yondruther plc agrees to pay a fixed dollar rate of 5.5%, and to receive a fixed sterling rate of 4.75%. Payments are exchanged half-yearly. The dollar interest is calculated on the notional principal amount of $100 million, so every 6 months the company pays out
$100,000,000 x 5.5% x 6/12 = $2,750,000.
At the same time, it receives sterling interest, calculated on the notional principal amount of £62.5 million. So every 6 months it receives
£62,500,000 x 4.75% x 6/12 = £1,484,375.
At maturity of the swap, it receives $100 million from its subsidiary in repayment of the loan, and immediately swaps this into sterling:
The overall economic effect is exactly the same as if it had lent £62.5 million to the subsidiary at fixed interest of 4.75%. The dollar lending has been effectively converted into sterling lending.
In this example, the company is hedging an existing loan. But if it wanted to hedge a new loan, it might enter into a swap with an initial exchange of currencies. At the start of the swap, it exchanges £62.5 million (perhaps funded from external borrowing in sterling) for $100 million, which it lends to its subsidiary. When the loan matures, it re-exchanges the $100 million for £62.5 million.
(First graphic - text above upper arrow should read "... principal $100m" rather than "... principal £100m". Text on left should refer to "...$100m loan" rather than "...£100m loan".
Second graphic - text on left should also refer to "$100m loan" rather than "£100m loan".)
