Swaps Doing Business Overseas Requires a Number

Swaps

Doing business overseas requires a number of strategies to manage foreign exchange rate risk. One of those techniques is the interest rate swap. A swap can also be used for domestic transactions as well. An interest rate swap is "an agreement between two parties to exchange one stream of interest payments for another, over a set period of time." There are several types of swaps. The main type is the plain vanilla swap. This type of swap consists of a fixed rate payment being exchanged for a floating rate payment. The two counterparties must come to an agreement over the rates to be paid. The counterparties are usually a corporate customer and a bank that acts as the market maker (Johnson, 2011). The counterparties typically engage in swaps to lower their risk (Loeys, 1985).

Swap pricing also tends to reflect comparative advantage. If a counterparty received no advantage from the swap, then the counterparty would have no incentive to engage in the swap. Thus, swaps are often conducted by counterparties where one has a pricing advantage in fixed interest rates and the other has a pricing advantage in floating rates.

Swaps have been adapted a foreign exchange hedging vehicle as well. This is because the expected change in the value of foreign currencies reflects expectations of the differential interest rates in those two countries. This is the condition known as interest rate parity. However, swaps can earn investors or corporations an opportunity to lower borrowing costs. This works because a company can have better credit in one country than in another. The counterparty might have the same situation with the countries reversed. This would create an opportunity for a swap, because the first company could borrow relatively cheaply in its home currency and the same would be the case for the counterparty.

While swaps are used to reduce risk, they also introduce risk. As Duffie and Singleton (1997) note, swaps contain default risk. Each counterparty faces the default risk of the other counterparty in the swap. Banks often seek to reduce their risk by reselling their side of the swap obligation, but a firm engaging a bank in a swap still faces default risk from the bank. Swap pricing therefore needs to take into account a number of different factors, including expectations of rate movement and currencies fluctuations, but also default risk.

As Allyannis & Olek (1997) point out, foreign currency swaps typically are done to take a foreign-denominated liability and turn it into a domestic liability.

Designing a Swap

There are a number of considerations that go into designing an interest rate swap, especially one related to a foreign subsidiary. The first thing is that there has to be some sort of risk that needs to be hedged. Dorchester is looking at three countries for its acquisition. The first is China. The yuan is pegged to the dollar, and has a very limited float as a result. The currency analysis previously conducted shows that the CNY-USD pairing is not subject to considerable risk. That is not to say that there isn't risk in the Chinese economy, but that risk is not priced into the currency because of the price controls of the Chinese government. Yet, should rise arise, the company could seek out a Chinese bank to do an interest rate swap between CNY and USD, since Chinese banks will be empowered to make such exchanges. The swap in that case would be purely financial, because the money from the Chinese subsidiary would probably not be repatriated, because of limits on capital outflows.

In Japan or South Africa, there are well-developed and modern banking systems that can facilitate such a transaction. However, neither Japanese nor South African banks have much presence in the U.S., so for Dorchester the swap would again probably have to go through a bank in the foreign country. That said, in either case there is significant foreign exchange rate risk, and that risk could be hedge with an interest rate swap. Dorchester could conceivably want a swap if it borrows in USD to pay for the acquisition, and then that acquisition primarily earns in foreign currency. That foreign currency exposure could be hedged.

The South African rand will be used for this example. It is more likely that Dorchester will operate in China, but the narrow band in which the yuan trades makes it a poor currency for illustrative purposes. The rand, on the other hand, can be used. So in this example, Dorchester has borrowed $10 million to finance the acquisition of Cape Television Manufacturing, and its facility in Stellenbosch. The current exchange rate for the rand is 9.50 to $1. The subsidiary can borrow in South Africa at a fixed rate of 4%. The one year forward market on the ZAR/USD pairing is 10.43 rand to the dollar.

The swap in this case would be that the subsidiary borrows in rand the $10 million, which would be 95 million rand. The value of this in one year in dollars given the forward rate is $9,108,341.30.

Dorchester's monthly interest payment in the U.S. starts at $5,833.33. In South Africa, it pays

R316,666.67, which is $33,333.33. This difference in the interest rates is reflected in the depreciation of the rand that is expected over that time.

The benefits of the swap are that Dorchester protects itself against depreciation of the rand in the coming year. It needs to use its earnings from South Africa to pay off the loan in the United States, and therefore it needs to guarantee the value of those flows. By borrowing at a fixed rate in South Africa that reflects the expected change in foreign exchange rates over the coming year, the company is locking in the value of those flows in a manner that not only gives it certainty with respect to the value of those flows, but also takes into account the expected change in the rates between the two countries. The interest rate in much higher on the South African borrowing but the value of the money coming back to the U.S. is also going to change significantly over the course of the year as it depreciates.

Conclusion