Introduction to Corporate Finance

ONLINE CHAPTER

Currency Swaps

The second-most common type of swap contract is the currency swap, in which two parties exchange

payment obligations denominated in different currencies. For example, a US company wishing to invest

in Switzerland would prefer to borrow in Swiss francs rather than in US dollars. If, however, the company

could borrow on more attractive terms in dollars (as is often the case) than in francs, a logical strategy

would be to borrow the money needed for investment in dollars, say, by issuing bonds, and then swap

payment obligations with a Swiss company seeking dollars for investment in the US. The Swiss company

would issue bonds that are denominated in Swiss francs.

The US company would make periodic Swiss franc payments to the Swiss company. The Swiss

company would make periodic dollar payments to the US company. The dollar payments made by the

Swiss company would cover the interest and principal payments on the dollar borrowing by the US

company, and the Swiss franc payments made by the US company would cover the interest and principal

payments on the Swiss franc borrowing by the Swiss company. By engaging in the swap, the US company

has transformed its dollar liabilities into Swiss franc liabilities, and the Swiss company has transformed

its Swiss franc liabilities into dollar liabilities.

Suppose that the US company issues $7 million in 10-year bonds that have a coupon rate of 8%.

The Swiss company issues SF10 million in 10-year bonds that also have a coupon rate of 8%. In this

example, we will assume that the companies have agreed on a fixed exchange rate in the swap contract

of US$0.70/SF. The two parties will exchange the principal amounts at contract origination. At the end

of the first six-month period, the US company will pay SF400,000 (SF10,000,000 × 0.08/2) to the Swiss

company in exchange for US$280,000 (US$7,000,000 × 0.08/2). These payments will occur every six

months until the termination date. On the termination date, the two parties will exchange principal

amounts again to terminate the contract. The principal amounts will then be used to retire the bonds

each company originally issued.

currency swap
A swap contract in which two
parties exchange payment
obligations denominated in
different currencies

FIGURE 23.8 SEMIANNUAL NET CASH FLOW FOR THE FLOATING-RATE PAYER IN A FIXED-FOR-FLOATING

SWAP WITH A NOTIONAL PRINCIPAL OF $10 MILLION

The interest payment made by the fixed-rate payer to the floating-rate payer is fixed and does not depend on the floating

interest rate (6-month LIBOR). However, because the payment by the floating-rate payer does depend on the LIBOR rate,

the net payment received by the floating-rate payer declines with increases in the 6-month LIBOR rate.

6-month

LIBOR (%)

$42,500

0

7% 7.85% 8.5%

–$32,500

Semiannual net cash flow to the floating-rate payer ($)