CFM13430 - Understanding corporate finance: derivatives: 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

  • 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 pay amounts equivalent to US dollar interest to the bank.
  • The bank will pay the company amounts equivalent to sterling interest.

At the end of the swap

  • 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.

Note that as the interest rate on the dollar loan is fixed the company could use a series of forward contract, one for each interest payment and one for the principal repayment.

Note also that the hedging of the loan here might at first sight seem to be abnormal treasury management as the company appears to be hedging an internal instrument with an external swap. However, looked at from the perspective of the group as a whole, the US subsidiary should be generating USD cash flows and from a consolidate accounting perspective the swap may be a ‘ net investment hedge’ - the UK parent is hedging its net investment in its US business and part of the investment in that subsidiary has been made by means of the USD loan. It might equally want to hedge the group’s USD exposure where its investment takes the form of equity. A currency swap with floating rate periodic payments would be a suitable instrument. There is a special tax regime for this type of hedging, called matching. See CFM62000+.

In this scenario the UK company is ‘long’ the USD by reference to the loan or, in terms of the consolidated accounts, its investment in its US business. The currency swap makes it ‘short’ US dollars (the currency it pays out) and ‘long’ sterling (the currency it gets in).