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University of Iowa
Art Durnev
International Corporate Finance
Spring 2012
CURRENCY SWAP EXAMPLE
Brazilian
capital
market
Canadian
capital
market
C$
8%
BR
C$
BR
C$
6%
Canadian
MNC
BR
C$
BR
7%
BR
Brazilian
subsidiary of
Canadian
MNC
BR
6%
C$
Brazilian
MNC
6%
Swap Bank
8%
BR
8%
BR
C$
C$
C$
9%
Canadian
subsidiary of
Brazilian
MNC
Original principal exchange
Debt service
Re-exchange of principal
Fig. 1
International Corporate Finance
Currency Swap Example
University of Iowa
Art Durnev
International Corporate Finance
Spring 2012
A Canadian MNC desires to finance a capital expenditure of its Brazilian subsidiary. The project
has economic life of five years. The cost of the projects is BR40,000,000. At the current exchange rate
of BR1.60/C$1.00, the parent firm could raise C$25,000,000 in Canadian capital market by issuing
five-year bonds at 8%. The parent then would convert C$ to BR to pay the project cost. The Brazilian
subsidiary would be expected to earn enough on the project to meet the annual debt service and to
repay the principal in five years. The only problem with this situation is that a long-term transaction
exposure is created. If C$ appreciates substantially against the BR over the loan period, it may be
difficult for the Brazilian subsidiary to earn enough in BR to service the C$ loan.
An alternative is for the Canadian parent to raise BR40,000,000 in the international bond market
by issuing EuroReal bonds (The Canadian parent might instead issue BR-denominated foreign bonds
in the Brazilian capital market). However, if the Canadian MNC is not well known, it will have difficulty
borrowing at a favorable rate of interest. Suppose the Canadian parent can borrow BR,000,000 for a
term of five years at a fixed rate of 7%. The current nominal borrowing rate for a well-known firm of
equivalent creditworthiness is 6%.
Assume a Brazilian MNC of equivalent creditworthiness has a mirror-image financing need. It has
Canadian MNC subsidiary in need of C$25,000,000 to finance a capital expenditure with an economic
life of five years. The Brazilian parent could raise BR40,000,000 in the Brazilian bond market at a
fixed rate of 6% and convert funds to C$ to finance the expenditure. Transaction exposure is created,
however, if the BR appreciates substantially against the C$. In this event, the Canadian subsidiary
might have difficulty earning enough in C$ to meet the debt service. The Brazilian parent could raise
bonds in Canadian capital markets but since it is not well known its borrowing cost would be, say, a
fixed rate of 9%.
A swap bank familiar with the financing needs of the two MNCs could arrange a currency swap
that would solve the double problem of each MNC, that is, be confronted with long-term transaction
exposure or borrow at disadvantageous rate. The swap bank would instruct each parent firm to raise
funds in its national capital market where it is well known and has a comparative advantage. Then
the principal sums would be exchanged through the swap bank. Annually, the Brazilian subsidiary
would remit to its Canadian parent BR2,400,000 in interest (6% of BR40,000,000) to be passed
through the swap bank to the Brazilian MNC to meet the BR debt service. The Canadian subsidiary of
the Brazilian MNC would annually remit C$2,000,000 in interest (8% of C$25,000,000) to be passed
through to the swap bank to the Canadian MNC to meet the C$ debt service. At the debt retirement
date, the subsidiaries would remit the principal sums to their respective parents to be exchanged
through the swap bank in order to pay off the bond issued in the national capital markets. The structure
of this currency swap is diagrammed in Fig.1
Fig. 1 demonstrates that there is a cost savings for each counterparty because of their relative
comparative advantage in their respective national capital markets. The swap also serves to
contractually lock a series of future foreign exchange rates for the debt service obligations of each
counterparty. At inception, the principal sums are exchanged at the current exchange rate of
BR1.60/C$1.00 = BR40,000,000/C$25,000,000.
International Corporate Finance
Currency Swap Example
University of Iowa
Art Durnev
International Corporate Finance
Spring 2012
Each year prior to debt retirement, the swap agreement calls for the counterparties to exchange
BR2,400,000 of interest on the BR debt for $2,000,000 of interest on the C$ debt; this is a contractual
rate of BR1.20/C$1.00. At the maturity date, a final exchange, including the last interest payments and
the re-exchange of the principal sums, would take place: BR42,400,000 for C$27,000,000. The
contractual exchange rates for each counterparty to meet its debt service obligations over the term of
swap.
Suppose that a year after the C$-BR swap was arranged, interest rates have decreased in
Canada from 8% to 6.75% and in Brazil from 6% to 5%. Further assume that because of the Canadian
rate decreased proportionally more than the Brazilian rate, the C$ appreciated versus the BR. Instead
of being BR1.5704/C$1.00 as expected, it is BR1.59/C$1.00. One or both counterparties might be
induced to sell their position in the swap to a swap dealer in order to refinance at the new loan rate.
The market value of the Canadian C$ debt is C$26,064,505; this is the present value of the four
remaining coupon payments of C$2,000,000 and the principal of C$25,000,000 discounted at 6.75%.
2,000,000 / (1 + 0.0675) + 2,000,000 / (1 + 0.0675) 2 + 2,000,000 / (1 + 0.0675)3 +
(2,000,000 + 25,000,000) / (1 + 0.0675)4 = 26,064,505.
Similarly, the market value of the BR debt at the new rate of 5% is BR41,418,380.
2,400,000 / (1 + 0.05) + 2,400,000 / (1 + 0.05)2 + 2,400,000 / (1 + 0.05)3 +
(2,400,000 + 40,000,000) / (1 + 0.05)4 = 41,418,380.
The Canadian counterparty should be willing to sell its interest in the currency swap for
C$26,064,505 – (1/1.59BR/C$) * BR41,418,380 = C$15,209.
That is the Canadian counterparty should be willing to accept C$15,209 to give up the stream of C$ it
would receive under the swap agreement in return for not having to pay the BR stream. The Canadian
MNC is then free to refinance the C$25,000,000 (8%) debt at 6.75%, and perhaps into a new currency
swap.
From the Brazilian counterparty’s perspective, the swap has a value of
C$41,418,380 – 1.59BR/C$ * C$26,064,505 = -BR24,183.
International Corporate Finance
Currency Swap Example
University of Iowa
Art Durnev
International Corporate Finance
Spring 2012
The Brazilian counterparty should be willing to pay BR24,183 to sell the swap, that is, give up the
stream of BR in return of not having to pay the C$ stream. The Brazilian MNC is then in a position to
refinance the BR40,000,000 (6%) debt at the new rate of 5%. The Brazilian firm might also enter into a
new currency swap.
International Corporate Finance
Currency Swap Example