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INTERNATIONAL CAPITAL: Data on the Extent of Derivative Markets 3

Posted by Connie R. Aponte on July 20, 2014 in INTERNATIONAL CAPITAL |

Some Specific Examples of Derivative Products and Associated Gross Capital Flows

Currency Swap

The initial example is a plain vanilla currency swap in its most common context.

Suppose that IBM sells DM bonds in Germany to shave some basis points from its finance costs–German fund managers find IBM securities desirable for diversification purposes but insist on DM settlement. IBM wants dollar liabilities, however, because of the nature of its earning stream. It enters a currency swap with a US bank, equivalent to a stack of forward exchange contracts in which IBM pays dollars at pre-determined exchange rates and receives the DM needed to cover its bond obligations.

In its net position, IBM is then a dollar debtor; and the bank has acquired the currency risk. Similarly, Daimler-Benz also can save basis points by placing its bonds with a US pension fund, which also seeks diversification of credit risk, but it must denominate the bonds in dollars. Another, opposite currency swap is bom, perhaps with the original US bank as the natural, ultimate counter party. The US bank makes the market and takes a spread, but has no net currency position.

There is no net international movement of capital, but the two bond issues appear on-balance sheet as gross capital flows to be captured by the periodic snapshots of the balance-of-payments data. In the absence of the swaps, neither borrower may have found it beneficial to go to an offshore market and may have confined their borrowing to domestic lenders, leaving no tracks in the data on gross international capital movements. As off-balance sheet items, the swaps are not reported and are not captured in balance of payments data, except to the extent that collateral is demanded by the market making bank from one or both final counter parties!

Single Currency Interest Rate Swaps

It is natural that gross capital flows should arise from currency swaps, because a cross-border flow is at the heart of the swap deal. With interest rate swaps in a single currency, which account about 60% of the outstanding OTC notional value, the natural international aspect disappears. Nevertheless, such swaps are frequently associated with capital flows. Suppose that a highly rated US company borrows fixed interest dollars in London and enters a swap as a floating rate payer with a bank—it will pay three-month dollar LIBOR multiplied by the notional value of the swap at the same maturity as its bond.

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