690 Part Eight Risk Management
bre44380_ch26_673-706.indd 690 09/30/15 12:09 PM
Here are Possum’s cash flows (in millions):Year 0 Year 1– 4 Year 5
Stock Dollars Euros Dollars Euros Dollars Euros- Issue dollar loan + 10 −0.6 −10.6
- Swap dollars for euros − 10 + 8 +0.6 −0.4 +10.6 −8.4
- Net cash flow 0 + 8 0 −0.4 0 −8.4
Look first at the cash flows in year 0. Possum receives $10 million from its issue of dollar
notes, which it then pays over to the swap counterparty. In return the counterparty sends Pos-
sum a check for €8 million. (We assume that at current rates of exchange $10 million is worth
€8 million.)
Now move to years 1 through 4. Possum needs to pay interest of 6% on its debt issue,
which works out at .06 × 10 = $.6 million. The swap counterparty agrees to provide Possum
each year with sufficient cash to pay this interest and in return Possum makes an annual pay-
ment to the counterparty of 5% of €8 million, or €.4 million. Finally, in year 5 the swap coun-
terparty pays Possum enough to make the final payment of interest and principal on its dollar
notes ($10.6 million), while Possum pays the counterparty €8.4 million.
The combined effect of Possum’s two steps (line 3) is to convert a 6% dollar loan into a
5% euro loan. You can think of the cash flows for the swap (line 2) as a series of contracts
to buy euros in years 1 through 5. In each of years 1 through 4 Possum agrees to purchase
$.6 million at a cost of .4 million euros; in year 5 it agrees to buy $10.6 million at a cost of
8.4 million euros.^28Some Other Swaps
While interest rate and currency swaps are the most popular type of contract, there is a wide
variety of other possible swaps or related contracts. For example, in Chapter 23 we encoun-
tered credit default swaps that allow investors to insure themselves against the default on a
corporate bond.(^28) Usually in a currency swap the two parties make an initial payment to each other (i.e., Possum pays the bank $10 million and
receives €8 million). However, this is not necessary and Possum might prefer to buy the €8 million from another bank.
◗ FIGURE 26.3
Swap curves for three
currencies, November
2014.
Maturity, years
0
1
1.5
0.5
2
2.5
3
Sw
ap
rate,
%
3.5
Dollar
Euro
Yen
123456789 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30