This is part 6 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 6, we’ll provide a real world example of how swaps are constructed and executed.
We’ve discussed the workings of swaps on a very basic level at this point (parts 1 through 4) and even covered some of the basic questions asked by those seeking information on swaps and their function in the economy (part 5), but we have yet to outline a real world example of how two parties might initiate a swap (for the case of making a point, the yields discussed henceforth are theoretical and not tied to current market rates).
In this example, we’ll discuss how a company, Coca-Cola, would approach a bank, JPMorgan, to initiate a swap, and given the concept of a comparative advantage, both parties would ultimately benefit from a swap.
Coca Cola a Real World Example
Coca-Cola needs to raise $150 million for transactions over the next 5 years. In the United States, Coca-Cola is able to borrow $150 million at an interest rate of 4.50%, or 100-basis points above the 5-year U.S. Treasury Note (3.50%). However, outside of the United States, it is able to borrow at 4.20%, or 70-basis points above the 5-year U.S. Treasury Note. Thus, there is an incentive for Coca-Cola to seek funding outside of the United States so as to reduce its borrowing costs.
It turns out that outside of the United States, there is strong demand for non-U.S. Dollar bond issues, thus creating the necessity for Coca-Cola to issue debt in a currency other than U.S. Dollars. With New Zealand zero-coupon issues selling well in Europe at the time of its financing needs, Coca-Cola issues a N$367 million zero-coupon, 5-year Eurobond. With the New Zealand Dollar interest rate at 8%:
At the rates used in this example, Coca-Cola would thus take N$250 million of proceeds, or 68%, of its N$367 million issuance. Now Coca-Cola can easily obtain its desired $150 million by converting the N$250 million at the prevailing $/N$ rate of 0.6000.
But wait? Doesn’t this leave Coca-Cola exposed to currency fluctuations? Yes – which is why swaps come into play as a hedge against risks.
Instead of simply converting its proceeds, Coca-Cola enters into a 5-year swap agreement with JPMorgan, swapping the N$267 million for the desired $150 million. Accordingly, given the parameters of this example, Coca-Cola would pay JPMorgan 4.20%} over the life of the contract. When the contract matures, Coca-Cola would swap $150 million for N$267 million; and now Coca-Cola has eliminated its exposure to exchange rate fluctuations.
What about JPMorgan? The bank now bears the currency risk, so it must hedge as well. JPMorgan must find a New Zealand bank (or any counterparty) that is willing to make a swap U.S. Dollars for New Zealand Dollars.
JPMorgan and Rabobank agree to a swap contract, with JPMorgan making annual payments of LIBOR -50-basis points. However, Rabobank cannot take on the full N$267 million. Instead, it can only swap N$200 million, meaning JPMorgan still has currency exposure of N$67 million. JPMorgan can exchange its N$67 million in the foreign exchange spot market for $40 million.
To protect itself from further risk, JPMorgan would have to agree to a forward contract with Rabobank, exchanging its $40 million 5-years out at a predetermined rate. By using forwards, JPMorgan insulates itself from currency fluctuations entirely, given this example. Interest rate risks still exist (from the obligation to Rabobank), so it would thus enter into an interest rate swap with another bank that’s willing to exchange a floating rate for JPMorgan’s fixed rate.
Conclusion: both Coca-Cola and JPMorgan were able to hedge away their risks via a series of currency swaps and interest rate swaps, reducing potential losses to both company’s balance sheets and shareholders. Without swaps, Coca-Cola would be at risk of exchange rate fluctuations, likely forcing it to pay a higher borrowing cost than it otherwise would have.
In part 7 of 10 of this series, we will lay out the importance of currency swaps not on a micro level (company-to-company), but on a macro level (between central banks).