Published on July 23, 2008
Currency Swap TransactionsSukumar NandiIndian Institute of Management Lucknow : Currency Swap TransactionsSukumar NandiIndian Institute of Management Lucknow Swap Transactions : Swap Transactions The foreign exchange swap consists of either :The Combination of spot transaction with a forward transaction Sport purchase + forward sale Spot sale + forward purchase orthe combination of two forward transactions with different terms Forward purchase + forward sale Forward sale + forward purchase In a foreign exchange swap transaction, both transactions (e.g. the spot purchase and the forward sale) must be concluded at the same time. If they are not, the foreign exchange risk cannot be excluded. Slide 3: Renewal of a Forward Transaction Our example is based on a 6 month forward sale of US$100,000- at the exchange rate of SFr. 1.5313. Let us assume that the delivery of the goods, and therefore the receipt of payment will be delayed by 2 months. Export Ltd. therefore decides to extend the maturity date through a swap transaction. AssumptionSpot rate US$/SFr. : 1.5055 - 652-month swap rate (discount) : 0.0060 – 55 This swap rate is based on an interest rate differential of about 2.25% p.a. between US$ and SFr. and is calculated in the manner described earlier. Here, too the range of 60 to 55 stands for the bid and offered rates and works out at SFr. 0.0060 per US$. Slide 4: Export Ltd. now buys US$100,000 - at the middle rate of SFr 1.5060, value maturity date of the first forward transaction and sells them forward 3 months at the same time at SFr. 1,5000 ! The exact determination of the foreign exchange spot rate is of little importance for the hedging costs as long as it is roughly in line with the prevailing spot rate. As is often done in professional trading, an even rate was chosen in the example just mentioned. It is obvious, however, that additional hedging costs will be incurred in our case since Export Ltd. will obtain the currency with a higher interest rate only at a later date than originally expected. Slide 5: However, the determination of the forex spot rate will in every case have an impact on the cash flow. This can be explained by describing the individual steps involved : Original Forward TransactionProceeds from from the forward transaction of US$100,000 - at SFr 1.5313, credited at the valuedate of the original maturity SFr. 153,130. - Swap for the Renewal ofthe Forward TransactionPurchase US$100,000 - from the Bankat SFr. 1.5060, debited at the same value date as the original forwardtransaction (= closing out) SFr. 150,600. - Profit SFr. 2,530. - Slide 6: Forward sale of US$ 100,000 -to the Bank for 2 months atSFr. 1,5000 (1.5060 - 0.0060) SFr. 150,000. - + profit from renewal of forward transaction SFr. 2,530. - Effective proceeds after renewing the forward transaction SFr. 152,530. - The new net exchange rate amounts to SFr. 15253, i.e., the rate of the original forward transaction of SFr. 1,5313 less the cost of renewing the forward transaction amounting to SFr. 0.0060 per US$. Closing out resulted in a positive cash flow given the level of the spot rate in our example. On the other hand, a cash drain would have been incurred if the spot rate had been higher than the original forward rate at the time the transaction was closed out. Slide 7: Advanced Drawing in a Forward Transaction The maturity date of a forward transaction can be advanced with the help of a swap in the same manner as it can be renewed, or extended, as was just outlined. In our example the Company ABC Ltd. which exports to Germany has globally hedged the currency risk for the current year by selling DM 3 million forward for value the end of June At the end of May, the firm already had at its disposal some DM 1 million from payment receipts. It wishes to use this D-mark amount as part cover for the existing forward contract. The original contract had been concluded at the exchange rate of 8410. AssumptionDM/SFr. spot rate 83.70-801-month swap rate (discount/premium) -0.01+0.04 Slide 8: This swap rate is based on an interest differential of about 0.25 % p.a. in favour of the swiss franc. The small difference results in minor costs on both the bid and offered side, which in our case come to SFr. 0.04 per DM 100. ABC Ltd. now sells the sum of DM 1 million to the Bank on a spot basis at SFr. 83.70 and simultaneously repurchases the DM at SFr. 83.74 for the same value as the original forward transaction. The 4 centimes per DM 100 totaling SFr. 400 - in our example constitute the entire costs for the advance drawing of the Swiss francs from the DM/SFr. transaction concluded with a maturity at the end of June. Here again the exact fixing of the spot rate, as explained earlier, is not relevant to the operation. Slide 9: Swap to shorten the Forward Transaction Sale of DM 1 million to the Bankat SFr. 83.70 on spot basis SFr. 837, 000 Forward repurchase of DM 1 millionas of end of June forward maturityat SFr. 83.74 SFr. 837,400 Swap costs for advance draw SFr. 400 Original Forward Transaction Forward sale of DM 1 million at SFr. 84.10 (part settlement of DM 3 million) under terms of original forward contract SFr. 841,000 - Swap costs for advance draw SFr. 400 Effective proceeds from DM 1 million after advance draw SFr. 840,600 Slide 10: The new net rate therefore comes to SFr. 84.06 i.e. the original forward rate of SFr. 84.10 less swap costs of SFr. 0.04. The hedging transaction has the added advantage that ABC Ltd. was able to generate SFr. liquidity during the advance drawing period (end of May to end of June) by spot selling D-mark. Slide 11: Instrument for Liquidity Control Any business organization may experience temporary liquidity squeezes in Swiss francs or other currencies. But frequently the firm may at the same time have a credit balance in another currency available. A swap transaction can have a balancing and cost-reducing effect in such a situation. Trading Ltd. has a temporary liquidity requirement for FF 1.5 million. Since the firm had cash funds in Swiss francs, it decides to procure the French francs for 1 month by means of FF/SFr. swap. Slide 12: Assumption : Spot rate FF/SFr. 25.15 - 201- month swap (discount) 0.09 - 8 Trading Ltd. concludes a swapby buying FF 1,500,000 at Sfr. 25.20 SFr. 378,000 and at the same time selling FF 1,500,0001-month forward at SFr. 25.11 SFr. 376,650 The swap costs thus amount to SFr. 1,350 Slide 13: Swap costs/Swap Income In the previous examples, swap costs or swap income were always expressed in absolute amounts. Frequently, these costs or revenues are shown annualized and in percentages. The following formula is useful in this context :Swap x 100 x 360) + (Swap x Interest Rate x Term in Days) Spot Rate x Term in Days Assumption :US$/SFr. : 1.5400-10Interest rate 6-month Euro-US$: 7¼ -7½ % p.a.6-month swap rate (discount): 0.0265-260Term: 183 days Slide 14: Swap costs:(0.0265x100x360) + (0.0265x7.25x183) 1.5400x183 = 3.5099%p.a. Swap income:(0.0260x100x360) + (0.0260x7.50x183) 1.5410x183 = 3.4457%p.a. Using the interest rate for 6-month Euro-US$ and the swap costs and swap income calculated, one can also compute the interest rate for 6-month Euro-SFr.:6month Euro-SFr. (bid): 7.25-3.5099=3.7401%p.a.6month Euro-SFr. (offered): 7.50-3.4457=4.0543%p.a.or 3 ¾-4% in the market. Slide 15: In the case of forward premiums (e.g. FF against US$), the swap costs or swap income must be added to the interest rate of the other currency and not deducted from it.