Case Study: Currency Swaps IBM and the World Bank

Underlying Situation The World Bank borrows funds internationally and loans those funds to developing countries for construction projects. It charges its borrowers an interest rate based upon the rate it has to pay for the funds. The World Bank looks for the lowest cost borrowing. Relevant interest rate in 19 1! ".#. rate! 1$% &very high rate due to the anti'inflation (onetary) West *er(any rate! 1+% #wit,erland rate! % &Best -hoice). .roble( for The World Bank! The #wiss govern(ent i(posed a li(it on World Bank borrowings in #wit,erland. The World Bank had borrowed its allowed li(it in #wit,erland and the sa(e was true of West *er(any.

In 19 1/ IB0 had large a(ounts of #wiss franc &-12) and *er(an deutsche (ark &340) debt and thus had debt pay(ents to pay in #wiss francs and deutsche (arks. IB0 and the World Bank worked out an arrange(ent in which the World Bank borrowed dollars in the ".#. (arket and swapped the dollar pay(ent obligation to IB0 in e5change for taking over IB06s #wiss franc and deutsche (ark obligations. The co(plete details of the swap have never been published in full. The following description follows a paper published by 3.R. Bock in #wap 2inance/ 4uro(oney .ublications.

 Specific I! IBM In the (id 19$9s/ IBM had issued bonds in 340 and -12. Bonds (aturity date! 0arch 79/ 19 :. Issued a(ounts! ' -12 +99 (illion/ with a coupon rate of :.1 $8% &p.a.) ;< coupon pay(ent ; -12 1+/7$8/999 &; -12 +990 5 . 9:1 $8) ' 340 799 (illion with a coupon rate of 19% &p. a.) ;< coupon pay(ent ; 340 79/99/999 &; -12 7990 5 .19)

SWITZ
-12 1+/7$80

IBM
340 790

GERMANY

3uring 19 1 the "#3 appreciated sharply against the 340 and -12. -hange in a 340 199 coupon pay(ent ' In 0arch 19 9/ #t; .81 1"#3 =340 ;< coupon ; "#3 81. 1 ' In >ugust 19 1/ #t; .79: "#3=340 ;< coupon; "#3 79.: #i(ilar situation with the -12. IBM enjoyed a sudden/ une5pected capital gain fro( the reduced "#3 value of its foreign debt liabilities. ?ote! IBM was e5posed to currency risk.

II! T)e World Ban& The World Ban& wanted debt in -12 and 340. But/ it was not allowed. It could issue "#3 debt/ at an attractive "#3 rate.

US$ '"U("N

U!S! Mar&et
US$ 'A(ITA#

W"R#$ BAN%

III! Solo*on Brot)er Both parties could benefit fro( "#3 for 340 and -12 swap. #olo(on Brothers proposed a si(ple currency swap!

SWITZ
-12 1+.7$80 US$ '"U("N
US$ '"U("N

IBM
340 790
-12 1+.7$80 340 790

GERMANY

USA
US$ 'A(ITA#

W"R#$ BAN%

#alo(on Brothers needed to deter(ine the details of "#3 bond! Issue a(ount &"#3 capital)/ coupon/ pay(ent dates.
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@ S+ap $etail
The World Bank issued a "#3 bond. Issue date! >ugust 11/ 19 1/ settling on >ugust +8/ 19 1. >ugust +8/ 19 1 beca(e the ettle*ent date for the swap. The first annual pay(ent! 0arch 79/ 19 + A the ne5t coupon date on IB06s bonds 'i.e./ +18 days/ rather than the usual 7:9 fro( the swap starting date.

The first step was to calculate the value of the -12 and 340 cash flows. >t that ti(e/ the annual yields on si(ilar bonds were at % and 11%/ respectively. The initial period of +18'day (eant that the discount factors were calculated as follows!

%&scount 'actor =

1 $1 + y#
n 36(

"

?ote! y: BT0 of bond. That is/

yCHF: % for the -12 yDEM: 11%

n: the nu(ber of days till pay(ent.
!

The discount factors were calculated!

$ate 7.79. 7.79. 7.79. 7.79. 7.79.

$ay + 7 C 8 : +18 8$8 978 1+98 1:88

',.9889$$8 . C7719 . 1 +89 .$8 1 17 .$9+919C

$EM .9798$:C . C:C:8+ .$:+8 17 .: $919+ .:1 9+ 1

1(

?e5t/ the bond values were calculated! N(./',-0 ; 1+/7$8/999 D.9889$$8 E . C7719 E . 1 +89 E .$8 1 17F E +1+/7$8/999 D.$9+919CF ; ',- 12134563768!

N(./$EM0 ;

79/999/999 D.9798$:C E . C:C:8+ E .$:+8 17 E .: $919+F E 779/999/999 D.:1 9+ 11F ; $EM 491341:3;64.

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The ter(s of the swap were agreed upon on >ug 11/ 19 1. Thus/ The World Bank would have been left e5posed to currency risk for two weeks until >"* +8. The World Bank decided to hedge the above derived ?.G a(ounts with 1C'days currency forwards! 2t/1C'day; .C8 $+ "#3=-12 2t/1C'day; .799:+8 "#3=340. The World Bank needed a total a(ount of! "#3 $/$ C/9 9.89 to buy ',- 12134563768. E "#3 11$/$91/+$ .89 to buy $EM 491341:3;64H ;< a total of US$ ;9:378:3458!99 This a(ount needed to be divided in various pay(ents.
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.roble(! 2irst coupon pay(ent was in +18 days. The other pay(ents were based on a period of 7:9 days. >ssu(ing that the World Bank bond carried a coupon rate of 1:% &p.a.) with inter(ediary co((issions and fees totaling +.18%/ the net proceeds of .9$ 8 per "#3 (eant that the "#3 a(ount of the bond issue had to be! US$ ;9:378:3999=9.9$ 8 ; US$ ;1939993465. The BT0 on the World Bank bond was 1:. %. Recall/ the first coupon pay(ent involved +18 days only. Thus/ the first coupon pay(ent was eIual to!
13 "#3 +19/999/999&.1:)D+18=7:9F ; "#3 +9/9::/::$.

The cash flows are su((ari,ed in the following table!

$ate 7.79. 7.79. 7.79. 7.79. 7.79. YTM 'R N(. US$ +9/9::/::$ 77/:99/999 77/:99/999 77/:99/999 +C7/:99/999 15!8< 15< ;9:378:3458 ',1+/7$8/999 1+/7$8/999 1+/7$8/999 1+/7$8/999 +1+/7$8/999 8< 11< 5!168:< 12134563768 $EM 79/999/999 79/999/999 79/999/999 79/999/999 779/999/999 19< 491341:3;64

+ 7 C 8 :

Benefit to IBM!

?o longer e5posed to currency risk. -apital gain fro( "#3 appreciation. Jower coupon than current (arket rates.

Benefit to T)e World Ban&= >ccess to -12 and 340 financing A 14 also/ at lower rates than current (arket rates.

 T,E SWA(

WB receives two deposits fro( IB0! -12 191/7:$/C$ E 340 791/718/+$7

SWITZ
-12 1+.7$80 US$ '"U("N

IBM
340 790 -12 1+.7$80 340 790

GERMANY

IB0 receives a "#3 +98.C 80 deposit fro( WB

US$ '"U("N
IBM (AY RE'EI.E RE'EI.E $ate US$ ',$EM 4!49!8; ;939553556 1;346:3999 4939993999 4!49!84 4435993999 1;346:3999 4939993999 4!49!87 4435993999 1;346:3999 4939993999 4!49!8: 4435993999 1;346:3999 4939993999 4!49!85 ;7435993999 ;1;346:3999 44939993999

W"R#$ BAN%
"#3 +190 ; "#3 +98.C 80 &WB) E "#3 C.8180 &#B)

USA
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