5.5. USING FORWARD CONTRACTS (4): MINIMIZING THE IMPACT OF MARKET
IMPERFECTIONS 203
The Economic Equivalence between Back-to-back Loans and Spot-forward
Swaps
Let us go back to theusdloan from Buba to BoE, and let’s add some specific figures.
We then summarise the contract in a table:
Example 5.29
The little table below shows this deal from BoE’spoint of view: theusdloan in
the second column, thegbpdeposit in the third. (Ignore the fourth column for
the time being.) The rows show for each contract the promised payments attand
T, assuming a dollar loan of 100m, a spot rate ofusd/gbp2.5, and an effective
six-month rate of 3% on dollars and 5% on pounds. Outflows, from BoE’s point of
view, are indicated by the< >signs around the amounts.
usd100m borro’d gbp40m lent
at 3 percent at 5 percent
t usd100.0m <gbp40.0m> = spot purchase ofusd100m at 2.5
T <usd103.0m> gbp42.0m = forward sale ofusd103m @ 2.4523The funny thing is that if one looks at the table by date (i.e.row by row) rather
than by contract (i.e. column by column), one sees for dateta spot conversion of
usd100m intogbp, at the spot rate of 2.5. For the end date, there is a promised
exchange ofusd103m forgbp42m, which sounds very much like a forward deal.
Even the implied forward rate is the normal forward rate, as one can see by tracing
back the numbers behind that rate:
2 .4523 =103
42
=
100
40
1. 03
1. 05
=St
1 +rusd
1 +rgbp=F (5.11)
Thus, depending on one’s preferences, the promised cash flows can be laid down
either in two loan contracts that serve as security for each other, or in a spot
contract plus an inverse forward deal—a spot-forward swap. But the similarity goes
beyond the promised cashflows: even in the event of default the two stories still
have the same implication. If, say, BoE defaults, then under the two-loans legal
structure Buba will invoke the security clause, sell the promisedgbp42m in the
market rather than give them to BoE, and sue if there is any remaining loss. Under
the swap contract, if BoE defaults, Buba will invoke the right-of-offset clause, sell
the promisedgbp42m in the market rather than give them to BoE, and sue if there
is any remaining loss. Thus, the two contract structures are, economically, perfect
substitutes. But lawyers see lots of legal differences, and many of these make the
swap version more attractive than the mutual-loan version.
Legal Advantages of the Swap Contract
Simplicity. Legally speaking, structuring the contract as a spot-forward transac-
tion is simpler than the double loan contract described earlier.