Loans and financial matters

In a currency swap, each party makes interest payments to the other in different currencies. Consider this example. The U.S. retailer Target Corporation (NYSE: TGT) does not have an established presence in Europe. Let us say that it has decided to begin opening a few stores in Germany and needs €9 million to fund construction and initial operations. TGT would like to issue a fixed-rate euro-denominated bond with face value of €9 million, but the company is not very well known in Europe. European investment bankers have given it a quote for such a bond. Deutsche Bank, AG (NYSE: DB), however, tells TGT that it should issue the bond in dollars and use a swap to convert it into euros.
Suppose TGT issues a five-year US$10 million bond at a rate of 6 percent. It then enters into a swap with DB in which DB will make payments to TGT in U.S. dollars at a fixed rate of 5.5 percent and TGT will make payments to DB in euros at a fixed rate of 4.9 percent each 15 March and 15 September for five years. The payments are based on a notional principal of 10 million in dollars and 9 million in euros. We assume the swap starts on 15 September of the current year. The swap specifies that the two parties exchange the notional principal at the start of the swap and at the end. Because the payments are made in different currencies, netting is not practical, so each party makes its respective payments.
Thus, the swap is composed of the following transactions: 15 September:
DB pays TGT €9 million TGT pays DB $10 million
Each 15 March and 15 September for five years: DB pays TGT O.O55(180/36O)$lO million = $275,000
TGT pays DB 0.049(180/360) €9 million = €220,500 15 September five years after initiation:
DB pays TGT $10 million TGT pays DB €9 million
Note that we have simplified the interest calculations a little. In this example, we calculated semiannual interest using the fraction 1801360. Some parties might choose to use the exact day count in the six-month period divided by 365 days. LIBOR and Euribor transactions, the predominant rates used in interest rate swaps, nearly always use 360 days.
Note that the Target-Deutsche Bank transaction looks just like TGT is issuing a bond with face value of €9 million and that bond is purchased by DB. TGT converts the €9 million to $10 million and buys a dollar-denominated bond issued by DB. Note that TGT, having issued a bond denominated in euros, accordingly makes interest payments to DB in euros. DB, appropriately, makes interest payments in dollars to TGT. At the end, they each pay off the face values of the bonds they have issued. We emphasize that the Target-Deutsche Bank transaction looks like what we have just described. In fact, neither TGT nor DB actually issues or purchases a bond. They exchange only a series of cash flows that replicated the issuance and purchase of these bonds.
It takes the dollars and passes them through to DB, which gives TGT the €9 million it needs. On the interest payment dates, the swap generates $275,000 of the $300,000 in interest TGT needs to pay its bondholders (Panel B). In turn, TGT makes interest payments in euros. Still, small dollar interest payments are necessary because TGT cannot issue a dollar bond at the swap rate. At the end of the transaction, TGT receives $10 million back from DB and passes it through to its bondholders (Panel C ) .TGT pays DB f9 million, thus effectively paying off a euro-denominated bond.

As we noted earlier, a swap has a termination or expiration date. Sometimes, however, a party could want to terminate a swap before its formal expiration. This scenario is much like a party selling a bond before it matures or selling an exchange-traded option or futures contract before its expiration. With swaps, early termination can take place in several ways. As we mentioned briefly and will cover in more detail later, a swap has a market value that can be calculated during its life. If a party holds a swap with a market value of $125,000, for example, it can settle the swap with the counterparty by having the counter- party pay it $125,000 in cash. This payment terminates the transaction for both parties. From the opposite perspective, a party holding a swap with a negative market value can terminate the swap by paying the market value to the counterparty. Terminating a swap in this manner is possible only if the counterparties specify in advance that such a transaction can be made, or if they reach an agreement to do so without having specified in advance. In other words, this feature is not automatically available and must be agreed to by both parties.
Many swaps are terminated early by entering into a separate and offsetting swap. For example, suppose a corporation is engaged in a swap to make fixed payments of 5 percent and receive floating payments based on LIBOR, with the payments made each 15 January and 15 July. Three years remain on the swap. That corporation can offset the swap by entering into an entirely new swap in which it makes payments based on LIBOR and receives a fixed rate with the payments made each 15 January and 15 July for three years. The swap fixed rate is determined by market conditions at the time the swap is initiated. Thus, the fixed rate on the new swap is not likely to match the fixed rate on the old swap, but the effect of this transaction is simply to have the floating payments offset; the fixed payments will net out to a known amount. Hence, the risk associated with the floating rate is eliminated. The default risk, however, is not eliminated because both swaps remain in effect.
Another way to terminate a swap early is sell the swap to another counterparty. Suppose a corporation holds a swap worth $75,000. If it can obtain the counterparty’s permission, it can find another party to take over its payments. In effect, it sells the swap for $75,000 to that party. This procedure, however, is not commonly used.
A final way to terminate a swap early is by using a swaption. This instrument is an option to enter into a swap at terms that are established in advance. Thus, a party could use a swaption to enter into an offsetting swap, as described above.