Case Study FRM

Case Study: Currency Swaps
IBM and the World Bank

Presented by: 20BSP1396 Nayanika Saha
20BSP2964 Nishant Bharti
20BSP2597 Swati Choudhary
Background:
 Swap was originally developed by banks in the US to help large clients finding a way to control UK exchange in
1970s.
 Earlier, currency swaps were in existence in the form of back-to-back/ parallel loans.
 The World Bank borrows funds internationally and loans those funds to developing countries for construction
projects. It charges its borrowers an interest rate based upon the rate it has to pay for the funds. The World
Bank looks for the lowest cost borrowing.
 Relevant interest rate in 1981:
1) U.S. rate: 17% (very high rate due to anti-inflation monetarist policy)
2) West Germany rate: 11%
3) Switzerland rate: 8% (Best Choice).
 In 1981, IBM had large amounts of Swiss franc (CHF) and German deutsche mark (DEM) debt and thus had debt
payments to pay in Swiss francs and deutsche marks.
 So, IBM and the World Bank worked out an arrangement in which the World Bank borrowed dollars in the U.S.
market and swapped the USD payment obligation to IBM in exchange for taking over IBM's CHF and DEM
obligations.
Underlying Situation:
 IBM In the mid 1970s, IBM had issued bonds in DEM and CHF.
 Bonds maturity date: March 30, 1986.
 Issued amounts: - CHF 200 million, with a coupon rate of 6.1875% (p.a.) coupon payment = CHF 12.375M
(=CHF 200M * .061875)
 And DEM 300 million with a coupon rate of 10% (p. a.) coupon payment = DEM 30M (=CHF 300M * .10).
 During 1981 the USD appreciated sharply against the DEM and CHF.
 Change in a DEM 100 coupon payment –
 In March 1980, St = .5181USD /DEM , coupon = USD 51.81
 And In August 1981, St = .3968 USD/DEM , coupon= USD 39.68
 So, a 24% appreciation. Similar situation with the CHF.
 IBM enjoyed a sudden, unexpected capital gain from the reduced USD value of its foreign debt liabilities and
was also exposed to FX risk.
Problems:
With IBM :
 IBM had to pay huge taxes on the capital gains. It also had to pay penalties which were usually
attached to the prepayment of bonds having no option to call. The problem for IBM was clear. If it was
unable to unload its liabilities in DEM and CHF, then it would lose the opportunity to gain from the
surge in USD.
With World Bank :

 The Swiss government imposed a limit on World Bank borrowings in Switzerland. The World Bank had
borrowed its allowed limit in Switzerland and the same was true of West Germany.
 The Bank wanted to borrow more funds in DEM and CHF but was worried about saturation in the
bond markets, which could significantly dent its ability to borrow more in DEM and CHF at a favorable
rate.
 The World Bank wanted debt in CHF and DEM. But it was not allowed but It could issue USD debt, at
an attractive USD rate.
Swap Details :
 The World Bank issued a USD bond.
 Issue date: August 11, 1981, settling on August 25, 1981. August 25,1981 became the settlement date
for the swap.
 The first annual payment: March 30, 1982 – the next coupon date on IBM's bonds -i.e., 215 days,
rather than the usual 360 from the swap starting date.
 The first step was to calculate the value of the CHF and DEM cash flows. At that time, the annual
yields on similar bonds were at 8% and 11%, respectively.
 The initial period of 215-day meant that the discount factors were calculated as follows:
Swap Details :
Swap Details :
 The terms of the swap were agreed upon on Aug 11, 1981. Thus, The World Bank would have been
left exposed to currency risk for two weeks until AUG 25.
 The World Bank decided to hedge the above derived NPV amounts with 14-days currency forwards:
 Ft,14-day = .45872 USD/CHF
 Ft,14-day = .390625 USD/DEM.
 The World Bank needed a total amount of :
USD 87,784,089.50 to buy CHF 191,367,478, +
USD 117,701,278.50 to buy DEM 301,315,273 and
Total = USD 205,485,368.00
Solution :
 Salomon Brothers planned a deal under
which the World Bank had to borrow from
the US Eurobond market and convert the
borrowed funds into DEM and CHF
according to requirement on the spot
exchange market. The coupon payment and
principal repayment of this loan had to be
made by IBM to the World Bank. In
exchange, the World Bank had to make a
coupon payment and principal repayment
of IBM's existing DEM and CHF loans.
.
Thank you

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Case Study: Currency Swaps

IBM and the World Bank

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