ASSIGNMENT

(FINANCIAL PROJECTIONS OF ENERGY PLANT)

SUBMITTED TO:

SIR SALEEM UL HAQ

SUBMITTED BY: M.SHOAIB KALEEM

ROLL NO:

(MS13MBA032)

HAILEY COLLEGE OF BANKING AND FINANCE

UNIVERSITY OF THE PUNJAB, LAHORE.

Currency swaps are an essential financial instrument utilized by banks,

multinational corporations and institutional investors. Although these type of
swaps function in a similar fashion to interest rate swaps and equity swaps, there
are some major fundamental qualities that make currency swaps unique and thus
slightly more complicated. (Learn how these derivatives work and how
companies can benefit from them. Check out An Introduction To Swaps.)
TUTORIAL: Introduction To The Forex Market
A currency swap involves two parties that exchange a notional principal with one
another in order to gain exposure to a desired currency. Following the initial
notional exchange, periodic cash flows are exchanged in the appropriate
currency.
Let's back up for a minute to fully illustrate the function of a currency swap.
Purpose of Currency Swaps
An American multinational company (Company A) may wish to expand its
operations into Brazil. Simultaneously, a Brazilian company (Company B) is
seeking entrance into the U.S. market. Financial problems that Company A will
typically face stem from Brazilian banks' unwillingness to extend loans to
international corporations. Therefore, in order to take out a loan in Brazil,
Company A might be subject to a high interest rate of 10%. Likewise, Company B
will not be able to attain a loan with a favorable interest rate in the U.S. market.
The Brazilian Company may only be able to obtain credit at 9%.
While the cost of borrowing in the international market is unreasonably high, both
of these companies have a competitive advantage for taking out loans from their
domestic banks. Company A could hypothetically take out a loan from an
American bank at 4% and Company B can borrow from its local institutions at
5%. The reason for this discrepancy in lending rates is due to the partnerships
and ongoing relations that domestic companies usually have with their local
lending authorities. (This emerging market is making strides in regulation and
disclosure. See Investing In China.)

Setting Up the Currency Swap

Based on the companies' competitive advantages of borrowing in their domestic
markets, Company A will borrow the funds that Company B needs from an
American bank while Company B borrows the funds that Company A will need
through a Brazilian Bank. Both companies have effectively taken out a loan for
the other company. The loans are then swapped. Assuming that the exchange
rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both
Companys require the same equivalent amount of funding, the Brazilian company
receives $100 million from its American counterpart in exchange for 160 million
real; these notional amounts are swapped.
Company A now holds the funds it required in real while Company B is in
possession of USD. However, both companies have to pay interest on the loans
to their respective domestic banks in the original borrowed currency. Basically,
although Company B swapped BRL for USD, it still must satisfy its obligation to
the Brazilian bank in real. Company A faces a similar situation with its domestic
bank. As a result, both companies will incur interest payments equivalent to the
other party's cost of borrowing. This last point forms the basis of the advantages
that a currency swap provides. (Learn which tools you need to manage the risk
that comes with changing rates, check out Managing Interest Rate Risk.)
Advantages of the Currency Swap
Rather than borrowing real at 10% Company A will have to satisfy the 5% interest
rate payments incurred by Company B under its agreement with the Brazilian
banks. Company A has effectively managed to replace a 10% loan with a 5%
loan. Similarly, Company B no longer has to borrow funds from American
institutions at 9%, but realizes the 4% borrowing cost incurred by its swap
counterparty. Under this scenario, Company B actually managed to reduce its
cost of debt by more than half. Instead of borrowing from international banks,
both companies borrow domestically and lend to one another at the lower rate.
The diagram below depicts the general characteristics of the currency swap.
Figure 1: Characteristics of a Currency Swap

For simplicity, the aforementioned example excludes the role of a swap dealer,
which serves as the intermediary for the currency swap transaction. With the
presence of the dealer, the realized interest rate might be increased slightly as a
form of commission to the intermediary. Typically, the spreads on currency swaps
are fairly low and, depending on the notional principals and type of clients, may
be in the vicinity of 10 basis points. Therefore, the actual borrowing rate for
Companyies A and B is 5.1% and 4.1%, which is still superior to the offered
international rates.
Currency Swap Basics
There are a few basic considerations that differentiate plain vanilla currency
swaps from other types of swaps. In contrast to plain vanilla interest rate swaps
and return based swaps, currency based instruments include an immediate and
terminal exchange of notional principal. In the above example, the US$100 million
and 160 million reals are exchanged at initiation of the contract. At termination,
the notional principals are returned to the appropriate party. Company A would
have to return the notional principal in reals back to Company B, and vice versa.
The terminal exchange, however, exposes both companies to foreign exchange
risk as the exchange rate will likely not remain stable at original
1.60BRL/1.00USD level. (Currency moves are unpredictable and can have an
adverse effect on portfolio returns. Find out how to protect yourself. See Hedge
Against Exchange Rate Risk With Currency ETFs.)
Additionally, most swaps involve a net payment. In a total return swap, for
example, the return on an index can be swapped for the return on a particular
stock. Every settlement date, the return of one party is netted against the return
of the other and only one payment is made. Contrastingly, because the periodic
payments associated with currency swaps are not denominated in the same
currency, payments are not netted. Every settlement period, both parties are
obligated to make payments to the counterparty.
Bottom Line
Currency swaps are over-the-counter derivatives that serve two main purposes.
First, as discussed in this article, they can be used to minimize foreign borrowing
costs. Second, they could be used as tools to hedge exposure to exchange rate

risk. Corporations with international exposure will often utilize these instruments
for the former purpose while institutional investors will typically implement
currency swaps as part of a comprehensive hedging strategy.

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Examples[edit]

Suppose the British Petroleum Company plans to issue five-year bonds worth 100 million at
7.5% interest, but actually needs an equivalent amount in dollars, $150 million (current $/ rate
is $1.50/), to finance its new refining facility in the U.S. Also, suppose that the Piper Shoe
Company, a U. S. company, plans to issue $150 million in bonds at 10%, with a maturity of five
years, but it really needs 100 million to set up its distribution center in London. To meet each
other's needs, suppose that both companies go to a swap bank that sets up the following
agreements:

Agreement 1:

The British Petroleum Company will issue 5-year 100 million bonds paying 7.5% interest. It
will then deliver the 100 million to the swap bank who will pass it on to the U.S. Piper
Company to finance the construction of its British distribution center. The Piper Company will
issue 5-year $150 million bonds. The Piper Company will then pass the $150 million to swap
bank that will pass it on to the British Petroleum Company who will use the funds to finance the
construction of its U.S. refinery.

Agreement 2:

The British company, with its U.S. asset (refinery), will pay the 10% interest on $150 million
($15 million) to the swap bank who will pass it on to the American company so it can pay its
U.S. bondholders. The American company, with its British asset (distribution center), will pay
the 7.5% interest on 100 million ((.075)( 100m) = 7.5 million), to the swap bank who will
pass it on to the British company so it can pay its British bondholders.

Agreement 3:

At maturity, the British company will pay $150 million to the swap bank who will pass it on to
the American company so it can pay its U.S. bondholders. At maturity, the American company

will pay 100 million to the swap bank who will pass it on to the British company so it can pay
its British bondholders.
DEFINITION of 'Currency Swap'

A swap that involves the exchange of principal and interest in one

currency for the same in another currency. It is considered to be a
foreign exchange transaction and is not required by law to be shown on
a company's balance sheet.
INVESTOPEDIA EXPLAINS 'Currency Swap'

For example, suppose a U.S.-based company needs to acquire Swiss

francs and a Swiss-based company needs to acquire U.S. dollars. These
two companies could arrange to swap currencies by establishing an
interest rate, an agreed upon amount and a common maturity date for
the exchange. Currency swap maturities are negotiable for at least 10
years, making them a very flexible method of foreign exchange.
Currency swaps were originally done to get around exchange controls.

Exchange of one type of asset, cash flow, investment, liability, or payment for another. Common types of swap include: (1)
Currency swap: simultaneous buying and selling of a currency to convert debt principal from the lender's currency to the
debtor's currency. (2) Debt swap: exchange of a loan (usually to a third world country) between banks. (3) Debt to equity
swap: exchange of a foreign debt (usually to a Third World country) for a stake in the debtor country's national enterprises
(such as power or water utilities). (4) Debt to debt swap: exchange of an existing liability into a new loan, usually with an
extended payback period. (5) Interest rate swap: exchange of periodic interest payments between two parties (called
counter parties) as means of exchanging future cash flows

Derivatives - Currency Swaps

Like an interest rate swap, a currency swap is a contract to exchange

cash flow streams from some fixed income obligations (for example,
swapping payments from a fixed-rate loan for payments from a floating
rate loan). In an interest rate swap, the cash flow streams are in the
same currency, while in currency swaps, the cash flows are in different

monetary denominations. Swap transactions are not usually disclosed

on corporate balance sheets.
As we stated earlier, the cash flows from an interest rate swap occur
on concurrent dates and are netted against one another. With a
currency swap, the cash flows are in different currencies, so they can't
net. Instead, full principal and interest payments are exchanged.
Currency swaps allow an institution to take leverage advantages it
might enjoy in specific countries. For example, a highly-regarded
German corporation with an excellent credit rating can likely issue
euro-denominated bonds at an attractive rate. It can then swap those
bonds into, say, Japanese yen at better terms than it could by going
directly into the Japanese market where its name and credit rating may
not be as advantageous.
At the origination of a swap agreement, the counterparties exchange
notional principals in the two currencies. During the life of the swap,
each party pays interest (in the currency of the principal received) to
the other. At maturity, each makes a final exchange (at the same spot
rate) of the initial principal amounts, thereby reversing the initial
exchange. Generally, each party in the agreement has a comparative
advantage over the other with respect to fixed or floating rates for a
certain currency. A typical structure of a fixed-for-floating currency
swap is as follows:

Calculating the Payments on a Currency Swap

Let's consider an example:
Firm A can borrow Canadian currency at a rate of 10% or can borrow
U.S. currency at a floating rate equal to six-month LIBOR. Firm B can
borrow Canadian currency at a rate of 11% or U.S. currency at a rate of
floating rate equal to six-month LIBOR. Although Firm A can borrow
Canadian currency at a cheaper rate than Firm B, it needs a floatingrate loan. Additionally, Firm B needs a fixed-rate Canadian dollar loan.
The loan is for US$20 million, and will mature in two years.
Who has the comparative advantage?
To determine who has the comparative advantage, consider the fixed
rates for each firm for the currency required. In this case, Firm A's rate
of 10% is less than Firm B's rate of 11%, so Firm A has a comparative
advantage in the fixed currency. That leaves Firm B to have a
comparative advantage with respect to the floating rate.
A currency swap is a form of swap. It is most easily understood by comparison with an interest
rate swap. An interest rate swap is a contract to exchange cash flow streams that might be
associated with some fixed income obligationssay swapping the cash flows of a fixed rate loan
for those of a floating rate loan. A currency swap is exactly the same thing except, with an

interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are
in different currencies.
That difference has a practical consequence. With an interest rate swap, cash flows occurring on
concurrent dates are netted. With a currency swap, the cash flows are in different currencies, so
they cannot net. Full principal and interest payments are exchanged without any form of netting.
Suppose the spot JPY/USD exchange rate is 109 JPY per USD. Two firms might enter into a
currency swap to exchange the cash flows associated with

a five-year USD 100MM loan at 6-month USD Libor, and

a five year JPY 10,900MM loan at a fixed 3.15% semiannual rate.

All cash flows associated with those loans are paid:

initial receipt/payment of loaned principal,

payment/receipt of intere st (in the same currency) on that loan,

ultimate return/recovery of the principal at the end of the loan.

Vanilla currency swaps are quoted both for fixed-floating and floating-floating (basis swap)
structures. Fixed-floating swaps are quoted with the interest rate payable on the fixed sidejust
like a vanilla interest rate swap. The rate can either be expressed as an absolute rate or
a spread over some government bond rate. The floating rate is always flatno spread is
applied. Floating-floating structures are quoted with a spread applied to one of the floating
indexes.
Currency swaps can be used to exploit inefficiencies in international debt markets.
A corporation might need an AUD 100MM loan, but US-based lenders are willing to offer more
favorable terms on a USD loan. The corporation could take the USD loan and then find a third
party willing to swap it into an equivalent AUD loan. In this manner, the firm would obtain its
AUD loan but at more favorable terms than it would have obtained with a direct AUD loan. That
advantage must, of course, be balanced against the transaction costs and credit risk associated
with the swap. See Exhibit 1.

Exhibit 1: By entering into a currency swap with a third party, a corporation can convert a USD loan
into an AUD loan.

Just as a vanilla interest rate swap is equivalent to a strip of FRAs, a vanilla fixed-floating
currency swap is equivalent to a strip of currency forwards.
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