Kenneth R. Szulczyk
Volkswagen. Now Intel and Volkswagen can exchange their loans, using currency swaps. Intel
has euros to build a factory in Germany while Volkswagen has U.S. dollars to build a factory in
the United States. The key to understanding a forward-forward swap, the exchange involves two
cash flows, and a forward contract protects each cash flow.
A popular currency swap is a spot against a forward, and it comprised 57% of trades in
2004. Investors or businessmen can protect themselves from the exchange rate risk by
purchasing currency from a bank on the spot market today, and then they use a forward to
transfer the same currency back on a future date for a fixed exchange rate. For example, an
investor invests $10 million in Malaysia. He buys ringgit currency from an international bank
today and invests his money for one year in Malaysia. Afterwards, the investor cashes out his
ringgits and exchanges his ringgits for U.S. dollar with the original bank using a forward
contract. Thus, an investor protects himself from fluctuations in the exchange rate because he
exchanged his currency in the future for a known price.
International banks and investors created another financial instrument, Eurodollars that
reduce the foreign exchange rate risk. Banks create Eurodollars when a bank customer transfers
a deposit from the United States to a foreign bank. Then the bank does not convert the account
to the local currency, but keeps the account denominated in U.S. dollars. The Soviet Union
created Eurodollars because it accumulated U.S. dollars from selling petroleum to the
international markets. The Soviet leaders wanted to hold U.S. dollars but not in U.S. banks.
They were afraid the U.S. government would seize them, and they convinced European banks to
hold accounts in U.S. dollars.
Eurodollars allow banks to circumvent laws and regulations. In the United States, banks
originally did not pay interest on checking accounts. During the 1970s, depositors withdrew
their funds from their checking accounts as interest rates soared. In Britain, banks originally
could not grant loans outside of Britain. Nevertheless, Eurodollars allowed these banks to
circumvent these laws. U.S. banks could borrow Eurodollars from Britain instead relying on
domestic deposits. The U.S. banks paid market interest rates on the Eurodollar while British
banks could lend outside of Britain by using Eurodollars. Eurodollars were so successful that
many governments repealed regulations, and the U.S. dollar still dominates the Eurodollar
market.
Eurodollars are not limited to only Europe. During the 1970s, Organization of Petroleum
Exporting Countries (OPEC) had reduced their production of petroleum, causing the oil price to
surge. High oil prices caused a large inflow of U.S. dollars into the OPEC nations, and OPEC
became the largest source of Eurodollars. Currently, Japan and South Korea also have sizeable
deposits in U.S. dollars. Nevertheless, many countries are alarmed at the large U.S. debt and
massive trade deficits that cause an outflow of U.S. dollars into the international markets. Many
believe the U.S. dollar will depreciate. Accordingly, the Federal Reserve stopped publishing the
M3 definition of the money supply in 2006 that measured the quantity of Eurodollars.
Eurodollars created two offshoots: Euroloans and Eurobonds. Consequently, the principal
and interest payments for Euroloans and Eurobonds are denominated in U.S. dollars. For
example, a European bank lends to a Russian company, using an Euroloan. All terms of the loan
are in dollars, and Russia must repay the loan in dollars. Thus, the bank protects itself from