PART EIGHT Topics in Corporate Finance

At the same time, a German firm would like to obtain U.S. dollar financing. It can borrow cheaply in euros, but not in dollars. Both firms face a similar problem. They can borrow at favorable rates, but not in the desired currency. A currency swap is a solution. These two firms simply agree to exchange dollars for euros at a fixed rate at specific future dates (the payment dates on the loans). Each firm thus obtains the best possible rate and then arranges to eliminate exposure to exchange rate changes by agreeing to exchange currencies, a neat solution.

Imagine a firm that wishes to obtain a fixed-rate loan, but can only get a good deal on a floating-rate loan, that is, a loan for which the payments are adjusted periodically to reflect changes in interest rates. Another firm can obtain a fixed-rate loan, but wishes to obtain the lowest possible interest rate and is therefore willing to take a floating-rate loan. (Rates on floating-rate loans are generally lower than rates on fixed-rate loans; why?) Both firms could accomplish their objectives by agreeing to exchange loan payments; in other words, the two firms would make each other's loan payments. This is an example of an interest rate swap; what is really being exchanged is a floating interest rate for a fixed one.

Interest rate swaps and currency swaps are often combined. One firm obtains floating-rate financing in a particular currency and swaps it for fixed-rate financing in another currency. Also, note that payments on floating-rate loans are always based on some index, such as the one-year Treasury rate. An interest rate swap might involve exchanging one floating-rate loan for another as a way of changing the underlying index.

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