Funds Investing

Currency swap: Contract that commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.

A currency swap has three stages:

An initial exchange of principal: the two counterparties exchange principal amounts at an agreed exchange rate. This can be a notional exchange since its purpose is to establish the principal amounts as a reference point for the calculation of interest payments and the re-exchange of the principal amounts.

Exchange of interest payments on agreed dates based on outstanding principal amounts and agreed fixed interest rates.

1. Re-exchange of the principal amounts at a predetermined exchange rate so the parties end up with their original currencies.
2. Again this may be done to hedge risk, to speculate on changes in exchange rates, or to attempt to lower the cost of borrowing by borrowing in the currency in which the most favourable interest rates are available and then swapping into the currency that the firm needs to carry out its business. Whether this will be cheaper will depend among other things on the bid—offer spread. Read the rest of this entry »

A eurobond is a debt security handled internationally by syndicates, groups of bankers and/or brokers who underwrite and distribute new issues of securities or large blocks of outstanding issues. It is typically in bearer (non-registered form) and is issued outside the country of the currency in which it is denominated.

Borrowers and lenders are spread around the world, while the intermediaries are spread across Europe, with the majority of business being done from London. The market was founded in the early 1960s and has provided a competitive source of funding for borrowers who can tap discreet but important sources of finance. Japanese banks, pension funds and insurance companies have become important lenders in recent years and there are still plenty of wealthy individuals who prefer the anonymity offered by bearer securities. The eurobond market is the world’s second largest securities market after the US bond market in terms of trading volume and the third largest after the US and Japanese bond markets in terms of debt outstanding. Read the rest of this entry »

A major defence industry supplier, Death Mines plc, wishes to borrow £1 million for twelve years at a fixed interest rate to finance a new investment project. It could do so by issuing a straight eurobond but, as it is not well known in the market and does not have a high credit risk rating, would have to pay a coupon of 8 per cent which it regards as too high. The firm’s own bank is willing to lend Death Mines the required amount via a one-year floating rate note at a rate of 2 per cent over LIBOR, currently at 3.6 per cent.

Clearly, the floating rate loan is much cheaper at the moment, but LIBOR could easily rise over the period of the loan to such a level that Death Mines would finish up losing on the project. Thus, it enters into a contract with a swap bank, Border International, to pay to it 5 per cent on the principal, receiving in exchange LIBOR.

The position of Death Mines now is:

Pays to its own bank LIBOR + 2 per cent

Pays to Border 5 per cent

Receives from Border LIBOR

Net position — fixed rate loan at 7 per cent Read the rest of this entry »