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%.
SELECTED TOPICS IN FINANCIAL MANAGEMENT
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.
International Financial Management
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
SELECTED TOPICS IN FINANCIAL MANAGEMENT
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.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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