Reading 40: Risk Management Applications of Swap Strategie convert, company, another, generate, currency

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CFA Institute Area 8-11, 13: Asset Valuation
Session 13: Risk Management Applications of Derivatives
Reading 40: Risk Management Applications of Swap Strategies
LOS e: Explain how a company can generate savings by issuing a loan or bond in its own currency and using a currency swap to convert the obligation into another currency.

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A European firm can borrow at 8 percent in the U.S. and at 7 percent in Europe. A U.S. firm can borrow at 7 percent in the U.S. and at 8 percent in Europe. If the U.S. firm needs euros and the European firm needs dollars, then a currency swap could save each counterparty:

A) a minimum of 2 percent a loan on the foreign currency.

B) up to 0.5 percent (maximum) in a loan on the foreign currency.

C) up to 1 percent (maximum) in a loan on the foreign currency.

D) a minimum of 1 percent in a loan on the foreign currency.

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Answer and Explanation

The European firm can borrow euros at 7 percent and lend them at that rate to the U.S. firm who then saves 1 percent. The American firm, in turn, can borrow dollars at 7 percent and lend them at that rate to the European firm who then also saves 1 percent. It could also be possible for the American firm to re-lend the dollars at, say 7.5 percent, and still get the Euros at a lower rate, say 7.1 percent. Such an arrangement would mean the net rate on the loan is less than 7 percent for the American firm and more than 7 percent for the European firm. Such a discrepancy is unlikely, however, and the 1 percent (maximum) savings each is the only possible answer.

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A U.S. firm that borrows dollars and uses a plain-vanilla currency swap to obtain euros for an investment in Europe is most likely trying to:

A) increase the duration of the position.

B) create a synthetic pay-fixed dollar loan.

C) earn a fee.

D) lower borrowing costs.

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Answer and Explanation

Swaps can lower overall borrowing costs by allowing firms to borrow at a lower rate within their own country rather than paying a higher rate by borrowing directly in the foreign currency. For example, a U.S. borrower needing euros would have to pay a higher rate than a counterparty in Europe. The European counterparty can borrow at a lower rate and pass the savings on to the U.S. borrower who passes similar savings back via borrowing dollars in the U.S. and exchanging them for the euros. None of the other answers make sense.

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From the borrowers perspective, a plain-vanilla currency swap can create a synthetic fixed-rate euro loan when entered into as a:

A) fixed-rate receiver and combined with a floating-rate dollar loan.

B) floating-rate receiver and combined with a fixed-rate dollar loan.

C) fixed-rate receiver and combined with a fixed-rate dollar loan.

D) floating-rate receiver and combined with a floating-rate dollar loan.

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Answer and Explanation

The borrower has borrowed dollars and pays a floating rate. Becoming the floating-rate receiver in the swap will mean swapping the dollars and getting the floating-rate payments on the dollars to pass through to the original lender. The borrower will then pay fixed on the euros received.