In a previous Blog concerning currency swaps ( See, “ Don’t do the Swap”), I suggested that one way to gain a better understanding of this subject would be to identify the consequences of not entering into a swap. Another approach you could use to learn how currency swaps work is to identify the various cash flows that take place over the life of the swap.
Recall that the currency swap case that is presented in the BOK (See, References Below) concerns XYX that borrows $1,100,000 for a term of ten years in the US capital market. The funds are to be used for a 100 million Yen investment (USD/JPY 90.9091) in a Japanese business venture. XYZ plans to make semiannual interest payments to its US lenders with funds generated by the Japanese business venture. Accordingly, XYZ enters into a currency swap arrangement to limit its USD/JPY exchange rate exposure over the 10 year period. The cash flows associated with the swap will be as follows:
Initial Payments when Swap is Arranged
XYZ pays $1,100,000 to counterparty.
Counterparty pays 100 million Yen to XYZ. (USD/JPY 90.9091)
XYZ invests the100 million Yen in the Japanese business venture.
Interest Payments Activity Over 10 Years
XYZ makes semiannual interest payments in Yen to the counterparty, with funds that are generated by the Japanese business venture.
Counterparty makes semiannual interest payments to XYZ in dollars.
XYZ makes semiannual interest payments to its US lenders in dollars.
XYZ Net Semiannual Interest Payment
|XYZ pays counterparty 2,600,000 Yen @ USD/JPY 90.9091
|Counterparty pays XYZ
|XYZ pays US lenders
|XYZ Net Semiannual Interest Payment
Year 10 Payments when Swap is Closed
XYZ pays counterparty 100 million Yen
Counterparty pays XYZ $1,100,000 @ USD/JPY 90.9091
XYZ pays US lenders $1,100,000
Studying the currency swap from the perspective of the cash flows that take place over the life of the swap might help you to prepare to answer conceptual exam questions designed to test your understanding of how currency swaps can limit exchange rate exposure. Alternatively, this study strategy could also prepare you to answer a computational question where you are asked to calculate the XYZ net semiannual interest payment to its US lenders.
AFP Learning System, Treasury, Module Four, Chapter 9,. Pgs. 4-68 to 4-70
ETM 3rd Ed., Chapter 9, Pgs. 315 to 316