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Explain why corporations engage in swap-driven financing, and discuss the defining features of an interest rate and a currency swap. Why might a corporation prefer one type of swap contract over another?
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This solution discusses swap-driven financing.
Swap driven financing
The first actual currency swap is often cited as the 1981 transaction between the World Bank and IBM. The details of the swap are instructive. The World Bank had actually wanted to raise capital by borrowing Swiss francs, but had already saturated the Swiss market for its bonds. Moreover, the US market regarded World Bank bonds as having much less credit risk than did Swiss investors. IBM had previously financed with some Swiss franc debt, but had developed the view that the Swiss franc was going to appreciate in the future, relative to the US dollar. Therefore, IBM wanted to replace its Swiss franc debt with US dollar debt.
A major global bank noted that a currency swap might serve both parties; in the swap, IBM received periodic cash flows of Swiss francs from the World Bank, while the World Bank received US dollars from IBM. The World Bank could then borrow from US investors, planning to use the US dollar receipts from the currency swap to make payments bond payments. In this manner, the Swiss franc swap payments to IBM represented the net liability for the World Bank. Similarly, IBM could use the Swiss francs received from the World Bank to meet its existing Swiss franc debt obligations, while its US dollar payments to the World Bank represented its new de facto liability in US dollars.
IBMs motivation was clear. IBM had issued Swiss franc bonds but, subsequently, wanted to change that liability into a US dollar liability, since it predicted an appreciation of the Swiss franc. IBM used the currency swap as an expedient way to effectively convert Swiss franc debt into US dollar debt, without actually retiring the existing Swiss franc debt and reissuing new US ...
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