Cross-Currency Swap Questions 1) What is a cross-currency swap? 2) How do currency swaps and cross-currency swaps differ? 3) Why would a company use a cross-currency swap? 4) Diagram and/or explain the cash flows that will take place over the life of the swap. Base your answer on the following broad stages in the life cycle of the swap: a) start b) during c) maturity 5) The very name “cross-currency swap” would imply that BigWheels should be exposed to risk arising from changes in currency exchange rates. Does BigWheels have actual exposure to such risk? Why or Why not? 6) Do cross-currency swaps receive hedge accounting under FAS 133? Why or Why not? 7) What are the implications for BigWheels’ earnings based on your answer in question 6? 8) Since both the interest and principal payments of a cross- currency swap are not netted, BigWheels would most likely make the US $ denominated interest payments out of its US $ cash balance. For the sake of the following exercise, assume that BigWheels instead chooses to convert francs to dollars in order to meet its Exchange Contract Interest Payable obligations. Also assume that the value of the derivative is denominated in francs. Based on your understanding of FAS 133, and its implications on cross-currency swaps, record the journal entries for September 30, 1999 through September 30, 2001. Do not worry about closing the books at the end of the
Transcript
Cross-Currency Swap Questions
1) What is a cross-currency swap?
2) How do currency swaps and cross-currency swaps differ?
3) Why would a company use a cross-currency swap?
4) Diagram and/or explain the cash flows that will take place over the life of the swap. Base your answer on the following broad stages in the life cycle of the swap:
a) start
b) during
c) maturity
5) The very name “cross-currency swap” would imply that BigWheels should be exposed to risk arising from changes in currency exchange rates. Does BigWheels have actual exposure to such risk? Why or Why not?
6) Do cross-currency swaps receive hedge accounting under FAS 133? Why or Why not?
7) What are the implications for BigWheels’ earnings based on your answer in question 6?
8) Since both the interest and principal payments of a cross-currency swap are not netted, BigWheels would most likely make the US $ denominated interest payments out of its US $ cash balance. For the sake of the following exercise, assume that BigWheels instead chooses to convert francs to dollars in order to meet its Exchange Contract Interest Payable obligations. Also assume that the value of the derivative is denominated in francs. Based on your understanding of FAS 133, and its implications on cross-currency swaps, record the journal entries for September 30, 1999 through September 30, 2001. Do not worry about closing the books at the end of the accounting period. Instead, allow your balances to accrue through out the two-year period to see the effects of these transactions in the aggregate.
Bonus question: Why would BigWheels be more apt to meet its interest payment obligations from its US $’s on hand (as opposed to exchanging francs as we did in the previous example)? Hint: By exchanging francs to US $’s, what will appear on BigWheels’ books that really shouldn’t be there?
9) Assume that BigWheels makes all US $ denominated disbursements out of its US $ Cash account balance. Suggest (and illustrate) a way that BigWheels could account for its cross-currency swap. Do not forget the requirements FAS 133 has
imposed on the firm. Are there any problems with this proposed method of accounting?
10) Assuming that you are no longer bound by FAS 133 requirements, suggest (and illustrate) your own method of accounting for BigWheels’ transactions. What are the advantages/disadvantages of using this method of accounting?
11) Look at the proposed amendment to FAS 133. What are its implications for cross-currency swaps?
12) Explain any strengths/weaknesses of the different methods of accounting for cross-currency swaps that you have not already discussed. Ie. FAS 133 accounting, verses the proposed changes, verses your own method. In your opinion, which of these is best? Consider the standpoint of both the company and possible investors in the company.
AbstractCase
OverviewQuestions
Teaching Notes
References
Cross-Currency Swaps Abstract
The objective of this case is to illustrate the implementation of a cross-currency swap to leverage a favorable borrowing rate in one currency into another. Students are shown how to account for a cross-currency transaction implemented by BigWheels, Inc. The case is designed to help students consider the implications of FAS 133 Hedge Accounting on Foreign Currency Transactions, and cross-currency swaps in particular.
A currency swap is an agreement to exchange a series of cash flows denominated in one currency for a series of cash flows denominated in another currency over a period of time. The interest rates, which determine the cash flows, are fixed. A cross-currency swap is simply a currency swap in which at least one of the interest rates contains a variable (or floating) component.
Cross-currency swaps differ from plain vanilla foreign currency swaps in a number of other ways:
The principal amounts are exchanged at maturity The principal amounts could also be exchanged at the start of the transaction.
If the principal amounts are not exchanged at the start, the parties may be subject to foreign exchange rate risk.
Since the payments are in different currencies, they are not netted.
The following case helps to foster understanding of the uses of, and accounting for, a cross-currency swap through the analysis of case questions. By working the case
questions, students will further understand 1) what a cross-currency swap is 2) why a company would enter into such a transaction 3) how to account for a cross-currency swap 4) the implications of FAS 133 and its proposed amendment on cross-currency swaps.
Students are expected to consult the following prior to attempting the BigWheels case:
Financial Accounting Series: Exposure Draft. Proposed Statement of Financial Accounting Standards. Accounting for Certain Derivative Instruments and Certain Hedging Activities (an amendment of FASB Statement No. 133). http://www.rutgers.edu/Accounting/raw/fasb/draft/amend133 _ ED.pdf (In particular, pay attention to paragraphs 21, 29, 36, 52, 38, and 40)
BigWheels Case Overview
BigWheels Incorporated, the designer of the millennial celebratory Ferris wheel in Paris, France, is at it again. The company, disheartened by the disappointing delay of the inaugural ride during the New Year’s celebration for the Y2K, has decided to construct a similar wheel in New York City encompassing the Statue of Liberty. The company hopes to have this wheel up and running for the New Year’s celebration for the year 2001. Due to the short-comings of its Paris venture, BigWheels has joined the calendar purist in claiming that the new millennium will actually begin with the year 2001, and that the year 2000 is actually the last year in the old millennium. Therefore, BigWheels is
marketing its new construction project as the first great symbol for the “real” new millennium.
Unknown to all but a few executives at BigWheels, the safety problems with the Paris wheel were discovered well before the December 31st delay. The BigWheels executives had the firm’s top engineers improve the Paris design and adapt it to the environmental conditions at Ellis Island as early as September of 1999. On September 30, 1999, the company had a 100,000,000-franc bond issue to raise money for the construction of the American wheel. The 2 year bonds were sold at face value and carried a fixed annual interest rate of 10% payable quarterly.
Prior to the bond issue in France, BigWheels explored the possibility of having a bond issue denominated in US dollars. It was determined that US investors would require a 12% fixed interest rate (as opposed to the 10% interest rate in francs). If BigWheels were to offer a floating interest rate, the US would require a return of LIBOR + 2.75% and the French market would require a return of LIBOR + 2.5%.
Although BigWheels required US $ to meet its construction expenses in New York, and wished to acquire a floating rate on its debt instruments to ensure that the fair value of its bonds were safeguarded, it chose to leverage its beneficial fixed-rate lending terms in France and issue bonds there. At this point, the cash flows that BigWheels would be required to pay were fixed and assured. However, if interest rates went down, the company would be paying too much interest for the value of its bonds. BigWheels decided to risk its cash flows in order to participate in a fair value hedge, which would assure that BigWheels was paying an appropriate rate of interest for the market conditions.
Therefore, BigWheels contacted a swap dealer and sold its 100,000,000 francs in exchange for $20,000,000 US dollars (based on the spot rate for September 30, 1999). Additionally, the companies entered into an agreement in which BigWheels would exchange variable dollar interest payments at LIBOR + 2.25% paid quarterly for the receipt of quarterly fixed payments of 2,500,000 francs (the amount needed to service the bond interest payable). In two years the companies would then once again exchange the principle amounts with BigWheels receiving 100,000,000 francs and paying back the $20,000,000. By exchanging the principal amounts at the on-set, BigWheels was safeguarded against fluctuations in the exchange rates.
This cross-currency swap can be thought of as three separate components:
· The 100,000,000 franc bond issue in France carrying a 10% annual interest rate,
· A “loan” to the exchange dealer of 100,000,000 francs with a 10% annual interest rate,
· And a “loan” from the exchange dealer for $20,000,000 with a floating interest rate of LIBOR + 2.25%.
In effect, BigWheels was able to acquire $20,000.000 worth of US denominated debt at a more favorable rate then it would have if it had directly incurred the debt in the US. The first two transactions (the bond issue in France and the “loan” of the francs to the exchange dealer) cancel each other out. What remains is the $20,000,000 “loan” from the exchange dealer to BigWheels.
Interest Rates
Exchange Rates:
LIBOR ($) Francs Dollars
9/30/99 7.25% 5 $1
12/31/99 7.00% 5.25 $1
3/30/00 7.50% 5.25 $1
6/30/00 7.25% 5 $1
9/30/00 7.25% 5 $1
12/31/00 7.50% 4.75 $1
3/30/01 7.00% 4.75 $1
6/30/01 7.00% 5 $1
9/30/01 7.25% 5 $1
AbstractCase
OverviewQuestions
Teaching Notes
References
Teaching Notes: Cross-Currency Swaps
1) What is a cross-currency swap?
A cross-currency swap is an agreement to exchange a series of cash flows denominated in one currency for a series of cash flows denominated in another currency over a period of time. At least one of the interest rates in the swap contains a variable (or floating) component.
2) How do currency swaps and cross-currency swaps differ?
Currency swaps have fixed interest rates, whereas cross-currency swaps have at least one variable interest rate. Also, cross-currency swaps differ from plain vanilla foreign currency swaps in the following ways:
The principal amounts are exchanged at maturity The principal amounts could also be exchanged at the start of the
transaction. Since the payments are in different currencies, they are not netted.
As in the BigWheels example, the company used a cross-currency swap to gain the best possible terms on its debt instruments. A company could also use a cross-currency swap if it was determined that company required funding in one currency when it had a surplus of debt funding in another. Using a cross-currency swap (with principal exchanges at both the inception of the swap and at maturity) would limit the company’s exposure to changes in the currency exchange rates over time. This type of transaction (under these circumstances) would most likely occur when the firm was also changing its position on whether it was more important to have the fair value of its debt insured or the cash flows from that debt guaranteed.
Applied Derivatives Trading – Beginners Guide to Interest Rate Swaps (IRS) explains the concept of an IRS to leverage favorable borrowing terms. It also illustrates the benefits to the parties involved. This same logic can then be applied to cross-currency swaps to better understand their purpose.
http://www.adtrading.com/adt3/begin3.htm
4) Diagram and/or explain the cash flows that will take place over the life of the swap between BigWheels and the exchange dealer. Base your answer on the following broad stages in the life cycle of the swap:
a) start
b) during
c) maturity
Start
During (Quarterly Payments)
Maturity
BigWheels $20,000,000
<-----------------------------
100,000,000 francs
------------------------------->
LIBOR + 2.25% (US $)
------------------------------->
10% fixed interest (francs)
<------------------------------
$20,000,000
------------------------------->
100,000,000 francs
Exchange Dealer
<------------------------------
At the start of the swap, BigWheels trades its 100,000,000 francs for $20,000,000. During the life cycle of the swap, BigWheels makes quarterly floating US $ payments based on an annual interest rate of LIBOR + 2.25%. In exchange for these $ denominated payments, BigWheels receives fixed quarterly payments based on a 10% fixed annual interest rate. These payments are received in francs (this amount is then paid to the French bondholders). At maturity, the principal amounts are once again exchanged with BigWheels paying the $20,000,000 and receiving 100,000,000 francs (which it then uses to settle the French bond obligation).
The illustration was adapted from one by Applied Derivatives Trading.
http://www.adtrading.com/ast3/begin3.htm
5) The very name “cross-currency swap” would imply that BigWheels should be exposed to risk arising from changes in currency exchange rates. Does BigWheels have actual exposure to such risk? Why or Why not?
Since the principal amounts are exchange both at the beginning and end of the swap, these amounts are not subject to fluctuations in the currency exchange rate. In essence, BigWheels has entered into two loan transactions, one to borrow $20,000,000 and one to lend 100,000,000 francs. If these transactions were viewed separately it would be comical to consider that these transactions would be subject to exchange rate fluctuations. When an American student goes to pay-off his educational debt does s/he care what the exchange rate is between the dollar and the franc, or even the British pound for that matter? No, of course not.
Assume that BigWheels made its exchange contract interest payments to the exchange dealer out of the original $20,000,000. If, by September 2001, the company had either
a) Generated enough cash flow from its American operation to cover these interest payments and any other disbursements that came from the $ Cash account, or
b) Acquired other $ denominated debt sufficient to meet the aforementioned payments,
Then BigWheels effectively shielded itself from currency exchange gains or losses throughout the life of the swap. The only exposure the company faced was at the inception of the swap when the principal amounts were determined.
If, on the other hand, BigWheels converted francs to US $’s to meet its cash flow obligations, the company would have been exposed to the changes in exchange rates. Furthermore, if the company had not generated significant cash flows in US $’s to recover whatever construction expenditures the New York wheel had necessitated by the swap’s maturity date, BigWheels could have been severely exposed to currency exchange risk.
6) Do cross-currency swaps receive hedge accounting under FAS 133? Why or Why not?
No, cross-currency swaps do not receive hedge accounting under FAS 133.
The DIG explains the necessary factors for a foreign currency hedging relationship to qualify for the preferred hedge accounting at http://www.rutgers.edu/Accounting.
BigWheels’ transaction fails to meet the necessary requirements on the following grounds:
· The debt does not qualify as an unrecognized firm commitment that may be designated as a hedged item in a foreign currency fair value hedge because the balance sheet recognizes BigWheels’ obligation to make interest payments and repay the principal amount.
· Paragraphs 21(c) and 29(d) preclude the interest payments to be either a hedged item or the hedged transaction in the fair value hedge because the interest payments are related to a recognized liability that is re-measured with changes in the fair value. These fair value changes are associated with the hedged risk reported in current earnings.
Therefore, the fact that BigWheels’ firm commitment has been recognized precludes it from getting preferential hedge accounting. The DIG comments that FAS 133 provides special accounting for interest-rate-based derivatives (IRS), but not for the foreign currency derivative. By structuring the swap as BigWheels has, it has limited its exposure to fluctuations in the derivative based on currency changes. This will somewhat mitigate the FASB’s requirement to mark-to market the derivative.
7) What are the implications for BigWheels’ earnings based on your answer in question 6?
Since BigWheels’ cross-currency swap does not qualify for hedge accounting treatment under FAS 133, the company will be required to report changes in the derivative in the company’s current earnings. This will cause undue volatility in BigWheels’ earnings over time. Even though BigWheels intends to hold the swap derivative until maturity, FAS 133 requires that the company’s earnings reports take a hit when the derivative declines in value and report gains when it increases in value. These are only paper gains and losses since the company has no intention of realizing these recognized changes in fair value.
Another problem with this method of accounting is the requirement to value the expected present value of the future cash flows from the derivative. This is completely contrary to everything the double-entry system has required thus far. As I previously mentioned, the BigWheels swap can be broken into three components (a bond issue and two loans). If a company enters into a loan transaction (whether as a lender or borrower) it should record on its books the payable or receivable for the principal amount, right? Now what about the interest payments? The company would record the interest revenue or expense as it is earned or incurred, correct? Well, FAS 133 is now suggesting that BigWheels carries the entire two years worth of receivables/payables on its books even though it does not actually have a current right/obligation for the entire interest amount. Where is the comparability between the company who enters into a “regular” loan for $20,000,000 with a floating annual interest rate of LIBOR + 2.25% payable quarterly and maturing in two years with BigWheels? The two transactions, although they achieve the same end result, are accounted for quite differently thanks to FAS 133.
When it comes down to it, everyone seems to lose. Companies must spend more time and money considering the FAS 133 consequences of its transactions. Additionally, companies will be spending more time and energy to constantly re-value its derivatives (and sometimes no matter how much good-faith effort is made a reasonably reliable value is impossible). Investors lose too. Comparability from one
firm to another is threatened. Investors will have more trouble assessing the volatility of a company’s earnings. Simply because earnings appear volatile does not necessarily mean that the firm experienced any real changes in its financial position or earnings over the period. Also, companies may be less apt to enter into hedges or derivative instrument transactions even though they may be in the best interest of the firm and the shareholders. For example, BigWheels could have simply chosen to issue US $ denominated bond at LIBOR + 2.75% even though it would cost the company an unnecessary 0.5% in interest.
8) Since both the interest and principal payments of a cross-currency swap are not netted, BigWheels would most likely make the US $ denominated interest payments out of its US $ cash balance. For the sake of the following exercise, assume that BigWheels instead chooses to convert francs to dollars in order to meet its Exchange Contract Interest Payable obligations. Also assume that the value of the derivative is denominated in francs. Based on your understanding of FAS 133, and its implications on cross-currency swaps, record the journal entries for September 30, 1999 through September 30, 2001. Do not worry about closing the books at the end of the accounting period. Instead, allow your balances to accrue through out the two-year period to see the effects of these transactions in the aggregate.
At the end of each quarter the exchange derivative is “marked to market” and an exchange gain or loss is recorded which would effect current earnings. The value of
the derivative is the balance in the receivable account less the balance in the payable account. Since the exchange receivable carried a fixed interest rate and was already denominated in francs, any gains or losses attributable to the swap came from the variable exchange interest payable account and any the changes in the franc/$ exchange rate, not the receivable.
Bonus question: Why would BigWheels be more apt to meet its interest payment obligations from its US $’s on hand (as opposed to exchanging francs as we did in the previous example)? Hint: By exchanging francs to US $’s, what will appear on BigWheels’ books that really shouldn’t be there?
By exchanging the principal amounts at both the beginning and the end of the swap, BigWheels effectively protected itself from risk due to changes in the currency exchange rate. The goal of the cross-currency swap was two-fold 1) to obtain US $ cash to meet construction expenses and 2) to obtain the most favorable borrowing terms possible. Since the exchange interest expense arising from the swap was
1) denominated in US $’s, and since
2) the company already had US currency to meet the obligation, and
3) the interest expense is better matched with the US operations than the Paris operations,
It is more likely that BigWheels paid its exchange interest expense with US $’s on hand. By exchanging francs to $’s (as in the previous example), BigWheels experienced changes in the derivative’s value based on fluctuations in the exchange rate. It is unlikely that the company actually experienced these gains and losses. Once again, unrealized profits and losses are being recognized.
9) Assume that BigWheels makes all US $ denominated disbursements out of its US $ Cash account balance. Suggest (and illustrate) a way that BigWheels could account for its cross-currency swap. Do not forget the requirements FAS 133 has imposed on the firm. Are there any problems with this proposed method of accounting?
This question relies on individual creativity and there is no one right or wrong answer. When assessing a student’s work look for a) logic, b) consistency in accounting, and c) reasonableness. The following is a possible method for accounting for the swap:
Bob Jensen’s SFAS 133 Accounting Glossary. http://www.trinity.edu/rjensen/acct5341/speakers/133glos.htm
Deloitte& Touche: Heads Up. "Foreign Currency Hedge Relationship-What Are the Key Considerations?" http://www.dttus.com/PUB/HEADSUP/5-4/attach07.HTM.
Equity Analytics, Ltd. "Currency Swaps - The Very Basics." http://www.e-analytics.com/fued17.htm
Financial Accounting Series: Exposure Draft. Proposed Statement of Financial Accounting Standards. Accounting for Certain Derivative Instruments and Certain Hedging Activities (an amendment of FASB Statement No. 133). http://www.rutgers.edu/Accounting/raw/fasb/draft/amend133_ED.pdf
