Ok am I missing something or are currency swaps are mush more difficult than the other swaps. Does anyone have any tips on this .
Currency swaps are just like interest swaps as far as calculations of rates go. The only difference is that you have to convert into the other currency to figure out the net payment.
there is no netting in currency swaps…I imagine
Currency Swaps are a really simple. Lets jus understand the basic mechanism first.
- A is a American Company which is planning on starting a business in UK. They approach a local UK Bank to borrow 1 Million Pounds.But since they are a foreign organization the bank feels that it is a bit risky to loan money to them. So they quote a really high rate of say, 10%.
- But A is a well established firm in the US , so if they wanted a loan in US they would have got it at a lower rate of 7%.
At the same time
- There is a Company B, which is a well established firm in UK facing a similar situation in the US. They need 80,000 USD for an investing in a project in US. They would be able to borrow this amount at a cost of 9% from the US Banks.
- But B can easily get a loan at 8% in UK
So these two companies decide to help each other out.
- A Borrows a loan from the bank (US) at the rate of 7 % and lends it to B at a rate of 8%.
- B Borrows a loan from the bank (UK) at the rate of 9% and lends it to A at a rate of 10%
Exchange rate is say, 0.8 USD/Pound. Now they both would be able to make money out of this deal. They borrow at a low cost and lend it at a higher cost. Thereby making money on the interest payments. ***
Steps in this process would be as follows:
- Borrow Local Currency (loan at low cost) and swap it for foreign currency ( as a loan at higher cost)
- Both the parties would have to make loan payments in the currency in which they borrowed. NOTE: There is ‘no netting in Currency Swaps’… both parties have to make the interest payments
- At the end of the tenor the entire prinicpal amount is returned is returned by both companies
If there was now swap option, they would have had to borrow at higger cost.
With Currency Swap your cost of borrowing goes down.
*** I havent solved the example completely-- I didnt want to bombard you with data… If you are clear with these( or if you find this too simple)…Jus lemme know… then we ll take it to the next step…
Simple examples are always helpful, but I have two comments.
Correct that to: B Borrows a loan from the bank (UK) at the rate of 8% and lends it to A at a rate of 10%
This statement is not correct. The objectve of the swap is not to make money but to get the required funding at a good rate for both parties. The different interest rates you see are nominal rates, not necessarily one making a profit off of the other.
I totally agree with your first point Dreary That was a typo !
But I am a bit confused about the second point I know that the primary aim is not to make money…but in the proces they do end up makin an extra buck…that is why i mentioned that line… Could u throw some light upon this issue?