Loans and financial matters

TGT has effectively issued a dollar-denominated bond and converted it to a euro- denominated bond. In all likelihood, it can save on interest expense by funding its need for euros in this way, because TGT is better known in the United States than in Europe. Its swap dealer, DB, knows TGT well and also obviously has a strong presence in Europe. Thus, DB can pass on its advantage in euro bond markets to TGT. In addition, had TGT issued a euro-denominated bond, it would have assumed no credit risk. By entering into the swap, TGT assumes a remote possibility of DB defaulting. Thus, TGT saves a little money by assuming some credit risk.
Returning to the Target swap, recall that Target effectively converted a fixed-rate loan in dollars to a fixed-rate loan in euros. Suppose instead that TGT preferred to borrow in euros at a floating rate. It then would have specified that the swap required it to make payments to DB at a floating rate. Had TGT preferred to issue the dollar-denominated bond at a floating rate, it would have specified that DB pay it dollars at a floating rate.
Although TGT and DB exchanged notional principal, some scenarios exist in which the notional principals are not exchanged. For example, suppose many years later, TGT is generating €10 million in cash annually and converting it back to dollars twice a year on
15 January and 15 July. It might then wish to lock in the conversion rate by entering into a currency swap that would require it to pay a dealer €10 million and receive a fixed amount of dollars. If the euro fixed rate were 5 percent, a notional principal of €400 million would generate a payment of 0.05(180/360)€400 million = €10 million. If the exchange rate is, for example, $0.85, the equivalent dollar notional principal would be $340 million. If the dollar fixed rate is 6 percent, TGT would receive 0.06(180/360)$340 million = $10.2 million. These payments would occur twice a year for the life of the swap. TGT might then lock in the conversion rate by entering into a currency swap with notional principal amounts that would allow it to receive a fixed amount of dollars on 15 January and 15 July. There would be no reason to specify an exchange of notional principal.
As we previously described, there are four types of currency swaps. Using the original Target-Deutsche Bank swap as an example, the semiannual payments would be
A.    TGT pays euros at a fixed rate; DB pays dollars at a fixed rate.
B.    TGT pays euros at a fixed rate; DB pays dollars at a floating rate.
C. TGT pays euros at a floating rate; DB pays dollars at a floating rate.
D.    TGT pays euros at a floating rate; DB pays dollars at a fixed rate.
Or, reversing the flow, TGT could be the payer of dollars and DB could be the payer of euros:
E.    TGT pays dollars at a fixed rate; DB pays euros at a fixed rate.
F.    TGT pays dollars at a fixed rate; DB pays euros at a floating rate.
G . TGT pays dollars at a floating rate; DB pays euros at a floating rate.
H. TGT pays dollars at a floating rate; DB pays euros at a fixed rate.
Suppose we combine Swap A with Swap H. With TGT paying euros at a fixed rate and DB paying euros at a fixed rate, the euro payments wash out and the net effect is
I. TGT pays dollars at a floating rate; DB pays dollars at a fixed rate. Suppose we combine Swap B with Swap E. Similarly, the euro payments again wash out, and the net effect is
J. TGT pays dollars at a fixed rate; DB pays dollars at a floating rate.
Suppose we combine Swap C with Swap F. Likewise, the euro floating payments wash out, and the net effect is
K.    TGT pays dollars at a fixed rate; DB pays dollars at a floating rate. Lastly, suppose we combine Swap D with Swap G. Again, the euro floating payments wash out, and the net effect is 1. TGT pays dollars at a floating rate; DB pays dollars at a fixed rate.
Of course, the net results of I and L are equivalent, and the net results of J and K are equivalent. What we have shown here, however, is that combinations of currency swaps eliminate the currency flows and leave us with transactions in only one currency. A swap in which both sets of interest payments are made in the same currency is an interest rate swap.