9 - currency swaps Flashcards
What is a swap?
A thing that has been or may be given in exchange for
something else
vanilla swap?
Simplest form of a swap
» Standardised product characteristics
» Standardised deal structure
» Standardised documentation
What is an exotic swap
Is a transaction in which at least one of the standardised features of
the Vanilla Swap is broken
» Simple Exotic one/two standardised features are amended
» Complex Exotic several standardised features are amended
What are vanilla interest rate swaps?
The exchange of cashflows arising from fixed interest rate interest falling due at a
pre-determined date for cashflows arising from interest falling due at a floating
interest rate over the same time period for the same principal amount.
* CURRENCY SWAPS
Vanilla Currency Swaps
The exchange of principal and interest payments in one currency for principal and
interest payments in another currency.
What are vanilla currency swaps?
The exchange of principal and interest payments in one currency for principal and
interest payments in another currency.
What are the three principal reasons for swapping?
- Absolute advantage
- Comparative advantage
- Transformative reasons
What is absolute advantage?
If two companies operating in separate markets have an absolute advantage for debt in their
respective home markets but would like to
borrow in a foreign currency, using a financial
institution as a “transformer” in the middle of
the transaction, the companies could take
advantage of their respective advantages and
arrange a “swap” that enables each party to
borrow at an advantageous rate
What is comparative advantage?
If two companies operating in separate markets have a comparative advantage for
debt in their respective home markets but
would like to borrow in a foreign currency,
a financial institution as the “transformer” in
the middle of the transaction could take
advantage and arrange a “swap” that enables
each party to borrow at an advantageous
rate but make a margin
What is transformative advantage?
If a company is able to borrow debt in one currency but wants the money in order to
expand in to another country it may be able
to swap obligations so that the cashflows
that arise from the investment better match
the source of funding used to make the
investment.
What are some key issues that currency swaps do not address?
» Exact Matching of Requirements
It is unlikely that such a perfect Principal match would exist in reality. Interest rates
could be fixed, however.
» Financial Institution Margins
The Financial institution in brokering the transaction is highly unlikely to perform this
function for no reward!
» Exchange Rate Risk (for the Transforming Financial Institution)
This example assumed that Exchange Rates would remain constant for the length of
the contract – highly unlikely but they could be fixed using another instrument … at a
cost!
Credit Risk (for the Transforming Financial Institution)
There is still significant credit risk in this model – if either party fails to pay, the other
party (or Financial Institution in the middle – see below) could be left with significant
liabilities!
» Liquidity Risk (for the Transforming Financial Institution)
In order to implement the Swap and to alleviate the counterparty credit risk, the
Financial Institution may have to use its credit lines to effect the transaction.
» Relative Taxation
May trigger tax implications that may be (dis)advantageous
» Credit Risk (for the Transforming Financial Institution)
In order to implement the Swap, the Financial Institution will have to take on significant
counterparty credit risk that it would have to manage.
» Exchange Rate Risk (for the Transforming Financial Institution)
To make the swap work, the FI has to take different payments in different currencies to
create an advantage for the companies and margin for itself. If the exchange rate
were to change, the profitability calculated could be inflated or disappear!
