Academic journal article Financial Management

Currency Swaps, Financial Arbitrage, and Default Risk

Academic journal article Financial Management

Currency Swaps, Financial Arbitrage, and Default Risk

Article excerpt

17 Another alternative to swap financing may be issuing foreign securities. The distinguishing aspect is that swaps are governed by contract law instead of securities law. This difference in legal treatment can have significant default implications.

18 See appendix for proof.

19 Incomplete markets are pointed out as an explanation for the existence and evolution of the swaps market in Smith, Smithson, and Wakeman (1986) and in Arak, Estrella, Goodman, and Silver (1988) even though no analysis of the issue in that context is provided. Note that market incompleteness other than market segmentation may cause the stated condition in Result 1 not to hold. Many recent studies have addressed the analysis of interest rate swaps. In these studies, there is an ongoing debate concerning the importance of financial arbitrage in explaining the existence of the interest rate swap market. Some that favor financial arbitrage as a motive argue that the quality spread differential between two markets presents a financial arbitrage opportunity that can be shared to the benefit of both parties. (See Beidleman (1985, 1992), Bicksler and Chen (1986), and Felgran (1987).) As a result of comparative advantage, their borrowing costs are unambiguously reduced. Implied (but not stated) in these arguments is that both parties increase their value through swapping. Other studies argue against this view by noting that the very process of exploiting this kind of opportunity should soon eliminate it. (See Smith, Smithson, and Wakeman (1986, 1988), Turnbull (1987), and Wall and Pringle (1989).) The second argument against financial arbitrage is that the swap should be a zero-sum outcome even if financial arbitrage is the source of their economic benefits. These studies rightfully dismiss the importance of financial arbitrage in an efficient, complete, perfect, and integrated world capital market.

Currency swaps, however, have been largely ignored in the swap literature. This study attempts to fill that gap. It focuses on currency swaps exclusively in the belief that substantial differences exist between currency swaps and interest rate swaps that warrant a separate analysis.(1)

With currency swaps, one has to frame the analysis within an international capital markets setting. Even if the generally accepted view is that domestic capital markets are integrated (efficient), there is growing empirical and theoretical support that international capital markets are segmented (inefficient). Segmentation of international capital markets may be caused by government restrictions on international portfolio holdings of individual investors. In most countries, there are limitations on individual investor's access to foreign securities. Thus, it is plausible to assume segmented capital markets as an environment in which firms conduct their international financial and real activities.

In such an environment, however, firms can design strategies to reap the potential profits created by restrictions on portfolio holdings of individuals because corporate projects are not subject to the same type of restrictions.(2) Firms have an advantage over individuals because they have income generated in both markets (real activities) and can design securities (claims against their income) that will have differential valuation in the two markets. One such transaction is a currency swap, which firms can use as a financing alternative.

This paper analyzes how firms with foreign projects can exploit international capital market segmentation via currency swaps. I show how capital market segmentation may lead to non-zero outcomes and why non-zero outcomes do not necessarily yield positive gains for both parties as put forward in the comparative advantage arguments based on rate differentials.(3) In default-free currency swaps, heterogeneous expectations are sufficient to achieve this result.

Another concern in the swap finance literature is a true understanding of the default implications of this contract. …

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