Minimum size of a swap contract is of the order of 5
million US dollar or its equivalent in other currencies. But there are swaps of
as large a size as 300 million US dollar, especially in the case of Eurobonds.
The US dollar is the most sought after currencies in swap deals. The dollar-yen
swaps represent 25 per cent of the total while dollar-deutschemark account for
20 per cent of the total. The swaps involving Euro are also likely to be
widely- prevalent in European countries.
Life of a swap is between
two and ten years. As regards the rate of interest of the swapped currencies,
the choice depends on the anticipation of enterprise. Interest payments are
made on annual or semi-annual basis.
Reasons for Currency Swap Contracts
At any given point of time, there are investors and
borrowers who would like to acquire new assets/liabilities to which they may
not have direct access or to which their access may be costly. For example, a
company may retire its foreign currency loan prematurely by swapping it with
home currency loan. The same can also be achieved by direct access to market
and by paying penalty for premature payment. A swap contract makes it possible
at a lower cost. Some of the significant reasons for entering into swap
contracts are given below.
Hedging Exchange Risk
Swapping one currency liability with another is a way
of eliminating exchange rate risk. For example, if a company (in UK) expects
certain inflows of deutschemarks, it can swap a sterling liability into
deutschemark liability.
Differing Financial Norms
The norms for judging credit-worthiness of companies
differ from country t6 country. For example, Germany or Japanese companies may
have much higher debt-equity ratios than what may be acceptable to US lenders.
As a result, a German or Japanese company may find it difficult to raise a
dollar loan in USA. It would be much easier and cheaper for these companies to
raise a home currency loan and then swap it with a dollar loan.
Credit Rating
Certain countries such as
USA attach greater importance to credit rating than some others like those in
continental Europe. The latter look, inter-alia, at company's reputation
and other important aspects. Because of this difference in perception about
rating, a well reputed company like IBM even-with lower rating may be able to
raise loan in Europe at a lower cost than in USA. Then this loan can be swapped
for a dollar loan.
Market Saturation
If an organisation has
borrowed a sizable sum in a particular currency, it may find it difficult to
raise additional loans due to 'saturation' of its borrowing in that currency.
The best way to tide over this difficulty is to borrow in some other 'unsaturated'
currency and then swap. A well-known example of this kind of swap is World
Bank-IBM swap. Having borrowed heavily in German and Swiss market, the WB had
difficulty raising more funds in German and Swiss currencies. The problem was resolved
by the WB making a dollar bond issue and swapping it with IBM's existing
liabilities in deutschemark and Swiss franc.
Parties involved
Currency swaps involve two parties who agree to pay each
other's debt obligations denominated in different currencies. Example
illustrates currency swaps.
Example
Suppose
Company B, a British firm, had issued £ 50 million pound-denominated
bonds in the UK to fund an investment in France. Almost at the same time,
Company F, a French firm, has issued £ 50 million of French franc-denominated
bonds in France to make the investment in UK. Obviously, Company B earns in
French franc (Ff) but is required to make payments in the British pound.
Likewise, Company F earns in pound but is to make payments in French francs. As
a result, both the companies are exposed to foreign exchange risk.
Foreign exchange risk exposure is eliminated
for both the companies if they swap payment obligations. Company B pays in
pound and Company F pays in French francs. Like interest rate swaps, extra
payment may be involved from one company to another, depending on the
creditworthiness of the companies. It may be noted that the eventual risk of
non-payment of bonds lies with the company that has initially issued the bonds.
This apart, there may be differences in the interest rates attached to these
bonds, requiring compensation from one company to another.
It is worth stressing here
that interest rate swaps are distinguished from currency swaps for the sake of
comprehension only. In practice, currency swaps may also include interest-rate
swaps. Viewed from this perspective, currency swaps involve three aspects:
- Parties
involve exchange debt obligations in different currencies,
- Each party
agrees to pay the interest obligation of the other party and
- On
maturity, principal amounts are exchanged at an exchange rate agreed in
advance.
0 Comments