Currency Swap

[The Funky Gibbon]

I have a question regarding a swap question from the tutorial handout (Tutorial 3 Q14).

It involves OzCorp and Hola engaging in a currency swap. I thought the aim of a currency swap was to borrow money in different currencies at cheaper rates. The question talks about not exposing themselves to foreign currency risk. What are they talking about in the question here? Surely their foreign exchange risk depends upon what currency their revenues are in?

 

[Gareth]

I've not been to the tutorial, so it would help if you posted the full question.

The answer is probably along the lines that a currency swap is an exchange of interest payments _and_ a capital sum on expiry. So if your firm has a known outgo in a foreign currency in say 1 years time along with some smaller payments during the year, a currency swap could be used to hedge most of the currency risk associated with these payments (instead of a forward).

 

[Graham Aylott]

In questions like this (involving the construction of a currency swap in order to reduce the cost of borrowing based on comparative advantage), when the question says "not exposing themselves to foreign currency risk", it simply means that whilst Hola wishes to borrow Dollars as cheaply as possible, it wants to have no overall exposure to Euro. (It will borrow Euro only because it has a comparative advantage in Euro, which it can exploit via the swap, so as to enable it to borrow the Dollars it actually wants more cheaply).

Thus, in its swap with the Bank, Hola will lend Euro to the bank at 5.3%, so as to exactly cancel the 5.3% it pays on the Euro it borrows elsewhere at 5.3% (because it has the comparative advanatge in Euro borrowing).

Likewise, when constructing the swap between OzCorp and the bank, OzCorp must lend $ to the bank at 6.0%, so as to make its two exposures to $ exactly cancel each other out, leaving it with no net exposure to $.