Exchange rate risk management using cross-currency swaps and swaptions.

At the Bretton Woods international monetary conference in 1944, a system of fixed exchange rates was set up, which existed until the early 1970s, when a floating exchange rate system was adopted. The authors of this article trace the development of financial innovations such as cross-currency swaps and swaptions to the collapse of the Bretton Woods agreement and increased concern regarding exchange rate risk. Through the use of examples, situations are examined in which a swap or a swaption may prove to be a better hedge against exchange rate risk than other financial products.

The erratic behavior of exchange rates since the collapse of the Bretton Woods agreement in 1973 has not prevented an unprecedented expansion of international capital flows. Clearly, exchange rate risk did not prove to be the barrier to capital flows that many observers feared it would become if the supporting foundation of exchange rate stability was removed.

However, since the dismantling of the Bretton Woods system, exchange rate risk has been greater than was generally anticipated. Neither theory nor experience suggested that exchange rates would be as volatile in a floating-rate environment as they have turned out to be. Fortunately, the exchange risk "beast" has been "defanged" by improvements in exchange rate risk management based on the expanded use of existing hedging instruments and the rapid development of new ones.

Swaps

Swap financing techniques were used in international finance before the collapse of Bretton Woods, but the relative stability of both exchange rates and interest rates under the Bretton Woods agreement inhibited their full development. With the advent of floating exchange rates, however, financial managers began to devote more attention to exchange rate risk management. Hedging with forward contracts expanded enormously, and a market developed in currency futures, multiplying the number of hedging transactions required. Moreover, the growing volatility of interest rates joined with the increasing volatility of exchange rates to push financial intermediaries and multinational companies to develop new risk management techniques.

The era of financial swaps began in 1981 when Salomon Brothers worked out a currency swap between IBM and the World Bank. Currency swaps have advanced since then, as reflected by the substantial growth of the swap market. (See Table 1.)

Table 1. Outstanding Swap Transactions (in U.S. $ millions)

                    12/31/87   12/31/88   12/31/89

Pound                10,505     17,704     33,466
U.S. dollar         162,606    269,477    354,166
Yen                  59,746    131,034    201,145
Deutsche mark        21,377     33,979     53,839
Others              113,328    187,062    256,045
Adjusted total(*)   187,781    319,628    449,331

                    12/31/90   12131/91

Pound                49,041      74,835
U.S. dollar         428,355     584,263
Yen                 244,787     360,088
Deutsche mark        72,310      95,178
Others              360,577     499,968
Adjusted total(*)   577,535     807,166

(*) Each currency swap involves two currencies. To avoid double counting, the total is, therefore, half the sum of the individual currency amounts, and the percentage in each currency adds to 200% of this total.

Source: International Capital Markets (Washington, D.C.: International Monetary Fund, 1993).

Measured in notional principal amounts and excluding one side of each swap, the currency swap market grew from a meager $5 billion outstanding at the end of 1981 to $860 billion outstanding at the end of 1992. (These amounts double when both sides of currency swaps are counted.) The U.S. dollar accounted for 36% of the total notional value of the $1.7 trillion outstanding at the end of 1992.

While the dollar leads all other currencies by a large margin, the popularity of other currencies is rising. From 1987 to 1992, the share of other currencies--counting both sides of the swaps--increased from 56% to 64%. The phenomenal growth of currency swaps reflects the benefits they provide in terms of cost savings, hedging, and the creation of synthetic assets.(1)

Swaptions

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