Currency Swap for a Subsidiary's Long-Dated Funding
A UK parent has a US subsidiary that needs USD 50,000,000 for five years. The parent can issue GBP debt at 5.20% fixed or USD debt at 6.10% fixed. The subsidiary can borrow USD at 6.60% or GBP at 5.60%. The parent wants to fund the subsidiary in USD but believes its comparative advantage is in GBP. A bank quotes a five-year GBP/USD cross-currency swap: parent pays USD fixed 5.95% and receives GBP fixed 5.05%, with principal exchange at inception and maturity at the then-current spot (initially 1.2700). The parent must decide whether to issue GBP and swap, or issue USD directly, and must consider credit, basis, and accounting implications. The subsidiary's functional currency is USD.
1. Compare the all-in USD cost of (a) issuing USD directly at 6.10% and (b) issuing GBP at 5.20% and entering the swap. Which is cheaper and by how much?
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(a) Direct USD issue: cost 6.10% fixed.
(b) GBP issue plus swap: parent issues GBP at 5.20%, receives GBP 5.05% from the swap, so net GBP cost = 5.20% - 5.05% = 0.15%. The parent pays USD 5.95% on the swap. All-in USD cost = 5.95% + 0.15% = 6.10%. The two routes are equal at 6.10%. The apparent comparative advantage (parent GBP 5.20% vs subsidiary GBP 5.60%, a 40bp advantage; subsidiary USD 6.60% vs parent USD 6.10%, a 50bp disadvantage) is fully captured by the bank's swap pricing, leaving the parent with no savings. This illustrates that in an efficient market, the swap dealer prices away the arbitrage. The parent should choose based on non-cost factors: issuance market access, investor demand, accounting (hedge accounting eligibility), and administrative burden. If the bank's quote were 5.90% USD payable, the swap route would cost 6.05% and save 5bp, which might justify the complexity. The treasurer should also check the principal exchange: at inception the parent receives USD 50,000,000 and pays GBP 39,370,079 (50,000,000/1.2700); at maturity the principal is re-exchanged at the then spot, creating FX risk on the principal unless the exchange is at the original rate. The treasurer must confirm whether principal is exchanged at original or prevailing rate, because a prevailing-rate exchange leaves a large FX exposure.
2. Explain the basis risk and accounting issues the parent must manage, and recommend documentation steps.
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Basis risk: the swap's floating or fixed legs may not perfectly offset the hedged item. If the parent's GBP interest is fixed and the swap receives GBP fixed, the GBP leg is matched, but the USD leg is fixed, so the net USD cost is fixed only if the swap is held to maturity. If the swap is terminated early, the parent faces a mark-to-market that depends on GBP/USD and rate movements, which may not be hedge-accounted. Cross-currency basis (the spread between GBP and USD floating rates) can move, affecting swap valuation and any collateral calls. Accounting: under hedge accounting, the parent must designate the swap as a cash flow hedge of the GBP interest and principal, document the risk management objective, the hedged item, the hedging instrument, and the effectiveness assessment method. The subsidiary's functional currency is USD, so the parent's GBP debt is a foreign-currency liability in the group's USD presentation; the swap must be assessed for effectiveness, and ineffectiveness (e.g., from basis or timing) is recognized in P&L. If hedge accounting is not applied, the swap's fair value changes hit P&L, creating volatility. Documentation steps: (1) formal hedge designation at inception; (2) contemporaneous memo describing the exposure, instrument, and effectiveness method; (3) periodic effectiveness testing (dollar-offset or regression); (4) disclosure of basis risk and collateral terms; (5) confirmation that the swap counterparty is approved and that ISDA/CSA terms are in place. The treasurer should also consider whether the subsidiary or parent is the contracting entity, because that affects which entity's functional currency drives the accounting.