Currency Swaps When issuing bonds in another country where the bonds are not denom-

Currency Swaps When issuing bonds in another country where the bonds are not denom-

inated in the base currency, the issuer is exposed to currency risk. One way to hedge this risk is to use currency futures contracts or currency forward contracts. While these derivative instruments allow an issuer to lock in an exchange rate, they are difficult to use in protecting against the currency risk faced when issuing a bond or when facing other long- term liabilities. The reason is that a currency futures or forward con- tract is needed to protect against each payment that must be made by the issuer. So, if a bond is issued with a maturity of 20 years and interest payments are made annually, 20 currency futures or forward contracts must be used for each year when payment is to be made. The major problem is that currency futures contracts have settlement dates that go out only one year and therefore cannot be used. Currency forward con- tracts can be obtained from a commercial bank for longer terms. How- ever, they become expensive because dealers in this market charge a larger spread for long-dated forward contracts.

Today, when an issuer wants to protect itself against bonds denomi- nated in a foreign currency, the treasurer will use a currency swap. Recall from our discussion in Chapter 4, a swap is an agreement whereby two counterparties agree to exchange payments. In an interest rate swap, only interest payments are exchanged. In a currency swap, there is an exchange of both interest and principal. The best way to explain a currency swap is with an illustration.

Consider two companies, a U.S. company and a Swiss company. Each company seeks to borrow for 10 years in its domestic currency; that is, the U.S. company seeks $100 million U.S.-dollar-denominated debt, and the Swiss company seeks CHF 127 million Swiss-franc- denominated debt. Suppose that both companies want to issue 10-year bonds in the bond market of the other country, denominated in the other country’s currency. That is, the U.S. company wants to issue the Swiss-franc equivalent of $100 million in Switzerland, and the Swiss company wants to issue the U.S.-dollar equivalent of CHF 127 million in the United States.

For this illustration we will assume the following:

1. At the time that both companies want to issue their 10-year bonds, the spot exchange rate between U.S. dollars and Swiss francs is one U.S. dollar for 1.27 Swiss francs.

2. The coupon rate that the U.S. company would have to pay on the 10- year Swiss-franc-denominated bonds issued in Switzerland is 6%.

3. The coupon rate that the Swiss company would have to pay on the 10- year U.S.-dollar-denominated bonds issued in the U.S. is 11%.

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By the first assumption, if the U.S. company issues the bonds in Switzerland, it can exchange the CHF 127 million for $100 million. By issuing $100 million of bonds in the U.S., the Swiss company can exchange the proceeds for CHF 127 million. Therefore, both get the amount of financing they seek. Assuming the coupon rates given by the last two assumptions, and assuming for purposes of this illustration that

coupon payments will be made annually, 12 the cash outlays that the companies must make for the next 10 years are summarized below:

Year U.S. Company

Swiss Company

Each issuer faces the risk that at the time the liability payment must

be made its domestic currency will have depreciated relative to the other currency, requiring more of the domestic currency to satisfy the liability. That is, both are exposed to foreign-exchange risk.

In a currency swap, the two companies will issue bonds in the other’s bond market. The currency swap agreement will require that:

1. The two parties exchange the proceeds received from the sale of the bonds.

2. The two parties make the coupon payments to service the debt of the other party.

3. At the termination date of the currency swap (which coincides with the maturity of the bonds), both parties agree to exchange the par value of the bonds.

In our illustration, these requirements mean the following.

a. The U.S. company issues 10-year, 6% coupon bonds with a par value of CHF 127 million in Switzerland and gives the proceeds to the Swiss company. At the same time, the Swiss company issues 10-year, 11% bonds with a par value of $100 million in the U.S. and gives the pro- ceeds to the U.S. company.

b. The U.S. company agrees to service the coupon payments of the Swiss company by paying $11,000,000 per year for the next 10 years to the Swiss company; the Swiss company agrees to service the coupon pay- ments of the U.S. company by paying CHF 7,620,000 for the next 10 years to the U.S. company.

12 In reality U.S. coupon payments are made semiannually. The typical practice for bonds issued in Europe is to pay coupon interest once per year.

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c. At the end of 10 years (this would be the termination date of this cur- rency swap because it coincides with the maturity of the two bond issues), the U.S. company agrees to pay $100 million to the Swiss com- pany, and the Swiss company agrees to pay CHF 127 million to the U.S. company.

This currency swap is illustrated in Exhibit 25.5. EXHIBIT 25.5 Illustration of a Currency Swap between a U.S. Company and a

Swiss Company Panel a: Initial Cash Flow for the Currency Swap

Panel b: Interest Servicing for the Currency Swap

Panel c: Termination of the Currency Swap

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Now let’s assess what this transaction has done. Both parties received the amount of financing they sought. The U.S. company’s cou- pon payments are in dollars, not Swiss francs; the Swiss company’s cou- pon payments are in Swiss francs, not U.S. dollars. At the termination date, both parties will receive an amount sufficient in their local cur- rency to pay off the holders of their bonds. With the coupon payments and the principal repayment in their local currency, neither party faces foreign-exchange risk.

In practice, the two companies would not deal directly with each other. Instead, either a commercial bank or investment banking firm would be involved as an intermediary in the transaction either as a bro- ker or a dealer. As a broker, the intermediary simply brings the two par- ties together, receiving a fee for the service. If instead the intermediary serves as a dealer, it not only brings the two parties together, but also guarantees payment to both parties. Thus, if one party defaults, the counterparty will continue to receive its payments from the dealer. Of course, in this arrangement, both parties are concerned with the credit risk of the dealer. When the currency swap market started, transactions were typically brokered. The more prevalent arrangement today is that the intermediary acts as a dealer.

In our illustration, we assumed that both parties made fixed cash- flow payments. Suppose instead that one of the parties sought floating- rate rather than fixed-rate financing. Assume in our illustration that instead of fixed-rate financing, the Swiss company wanted LIBOR-based financing. In this case, the U.S. company would issue floating-rate bonds in Switzerland. Suppose that it could do so at a rate of LIBOR plus 50 basis points. Because the currency swap calls for the Swiss company to service the coupon payments of the U.S. company, the Swiss company will make annual payments of LIBOR plus 50 basis points. The U.S. company will still make fixed-rate payments in U.S. dollars to service the debt obligation of the Swiss company in the United States. Now, however, the Swiss company will make floating-rate payments (LIBOR plus 50 basis points) in Swiss francs to service the debt obligation of the U.S. company in Switzerland.

Currency swaps in which one of the parties pays a fixed rate and the counterparty a floating rate are called currency coupon swaps.