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by Warren Edwardes
"Perpetual Swaps: Managing Currency Translation Exposures", Nov. 91, The Treasurer, London link
This article forms the
basis for a chapter in
"Key Financial Instruments: understanding and innovating in the world of derivatives" 4 February 2000, Commissioned by Financial Times Prentice Hall ISBN 0273 63300 7 London link
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This case study describes a product developed in 1988. Again the product was not developed in a vacuum but in response to repeated requests by clients for a solution to a problem.
The hedging of Transaction Exposure was described in the previous case study on the Break Forward. The problem solved through the creation of the Perpetual Currency Swap was that of Translation Currency Exposure. Both such exposures are fully described in Appendix 3 of Key Financial Instruments.
A number of company boards at that time increasingly felt that Translation exposure should be managed by them. The traditional method for managing such translation exposure was for companies to borrow in local currencies. Through such borrowing, natural hedging will occur. This case study describes the creation of a currency swap that was arguably more efficient than foreign currency borrowing: the Perpetual Currency Swap. This chapter illustrates the benefits of examining not just the pre-tax but the post-tax effect of managing translation exposures. Such an off balance sheet hedge can help to minimise balance sheet size and provide a more cost-effective solution.
Essentially, transaction exposure covers the valuation in a firms home currency of foreign currency receivable or payment. It concerns the valuation of real transactions. It deals with cash flow. Translation exposure, on the other hand, deals with a stock concept. It is the sensitivity of the value of a foreign currency denominated asset or liability to changes in the value of that foreign currency with respect to a firms home currency. A UK firm with a large US subsidiary is required to revalue the US subsidiary in Sterling terms on its annual balance sheet date. Even if the US subsidiary is highly profitable, a significant fall in the US Dollar with respect to the GB Pound would lead to a translation loss for the UK company.
I do not intend to discuss the pros and cons of Translation exposure management in detail as there is still quite a difference of opinion. This chapter assumes that hedging the Sterling value of a capital investment was regarded as a "good thing". It therefore walks through the background to the development of a novel, elegant, efficient and effective structure for hedging such translation exposures the Perpetual Currency Swap.
We, at Charterhouse bank, had been discussing such translation exposures for some time without any solution. By way of general tax education, a seminar was arranged at a major accountancy firm. It turned out to be quite a tedious presentation not helped by the poor air-conditioning on a hot summers day. The speaker droned on and on outlining the tax treatment of various derivative products the term "derivative" had by then arrived in the UK. I was just about to fall asleep when something he said jolted me out of my slumber. I began to doodle furiously. I had come up with a solution to our problem.
I find attending seminars extremely valuable but not for what I can learn at the seminars. Information can be gleaned from many a text book or downloaded from the internet. What I find really valuable, even listening to a lifeless monotonously read-out speech, is my lack of concentration. So often something the speaker says can spark an idea perhaps in quite a different field. Very often the most effective financial products are cross-markets products. A common place application or widely understood process in one market can be tweaked to provide a revolutionary product in a different market. "Think everywhere" I wrote in Chapter 2: how to capture the big new IDEA. I do my best thinking at seminars.
To my knowledge, the "Perpetual" or "Capital-Hedging Swap" first appeared in the Autumn of 1988 independently out of Midland Bank and Charterhouse Bank. Structures with some similarities were also produced by S. G. Warburg and Citibank. The swap was soon widely available from other banks through dissemination by corporate clients to their relationship banks in search of a better price and also through the movement of bank staff to other banks (See the separate chapter on ethics!). The swap structure has been variously known as the Capital-Hedging Swap, the Perpetual Currency Swap, the Revolving Currency Swap, the Callable Currency Swap, the Cancellable Currency Swap, the Evergreen Swap and the Extendible Swap.
Essentially the Perpetual Swap was a Cross Currency Cross Callable floating to floating interest rate swap with an undetermined maturity date. As with plain vanilla currency swaps there may or may not have been an exchange of principals at the beginning.
The floating/floating payments were typically linked to 12 month LIBOR so as to cover an annual accounting date. At the end of each LIBOR period both parties had the right to call or cancel the swap.
Economically, the swap replicated hedging through a rolled forward series of forward exchange contracts. Like a rolled foreign exchange contract, there was no cash settlement at the end of each leg. But unlike a rolled Forex contract, which would have fallen foul of Bank of England regulations against transactions at off-market rates, the swap was not rolled; it was simply not terminated until either party opted to do so. Moreover the cross option to determine the maturity date provided conditionality to the swap and deferred the disposal date for tax purposes.
There was a variable margin payable or receivable on one of the LIBORs. This reflected the bank's costs of capital, any mismatch between the Forex market and the LIBOR pair, the funding cost or benefit of any position built up through the bank swapping forward in the market and, of course, the bank's financial engineering profit.
To illustrate the Perpetual Swap for a United Kingdom plc investor with a subsidiary in the United States it consisted of:
* Start Date: Time (0)
UK plc effects a Sterling rights issue to buy a US company for USD 100 million. As the first leg of the Perpetual Swap it purchases the USD 100m out of Sterling at Spot(-2) from the bank Counterparty where Spot(-2) was the GBP/USD spot exchange rate quoted at Time(-2) for delivery at Time(0).
UK plc commits to pay at Time(365) an amount equivalent to the 12 month USD LIBOR fixed at Time(-2) on the USD 100m.
In addition, UK plc agrees to receive at Time(365) an amount equivalent to the 12 month GBP LIBOR also fixed at Time(-2), less a margin, on the Sterling amount of GBP 100/Spot(-2). The variable margin, quoted by the bank and agreed by UK plc, may be positive or negative depending on the Forex forward market .
UK plc agrees to sell USD 100m for Sterling at Spot(-2) to be exchanged at some future interest related payment date. When either party exercises its option to determine the exchange date the swap terminates.
At Time(363) both parties have the right to effect the termination of the swap as at Time(365). The bank quotes, if it so chooses, a margin above or below its payment of Sterling LIBOR for the following year for value Time(730). If acceptable, both parties agree for UK plc to pay 12 month USD LIBOR on the USD 100m and receive 12 month GBP LIBOR less the positive or negative margin on the original Sterling amount at Time(730).
If there is no agreement the transaction terminates as at Time(365) with the USD 100m exchanged for Sterling at Spot(-2). The LIBOR linked amounts determined at Time(-2) are exchanged.
* Time(728), Time(730)
The processes at Time(363) and Time(365) are repeated with either party having the option of terminating the swap at Time(730). Under mutual agreement, the swap continues for another year.
At the end of three years, say, the parties agree to terminate the swap as at Time(1095).
The swap terminates.
UK plc sells USD 100m for Sterling at the exchange rate Spot(-2). Delivery risk mitigation clauses could include settlement on a net basis against the spot exchange rate fixed at Time(1093).
There are several possible reasons for the termination of the swap. Reasons include: disagreement between UK plc and the bank on the margin; full utilisation of the bank's credit line; absence of a novation clause; UK plc's disposal of the underlying asset; and UK plc's capital gains tax (Capital Gains Tax) management.
* UK plc is uncomfortable about the size of the Sterling LIBOR margin and has not succeeded in renegotiating it.
Given that both parties have the right to terminate the swap there is no value in having a fixed margin below Sterling LIBOR. With a fixed margin the swap would result in being in one party's favour at the roll-over date. The termination provisions would be activated.
The variable margin quoted by the bank and the bank's right to terminate can be seen as major disadvantages to the structure. The savings generated through the use of the competitive one year Forex market and the credit line and capital efficiency of the product should more than compensate. The corporate treasurer, however, should place himself in a position to calculate and argue for a fair margin.
* Exchange rates have substantially moved with the US dollar appreciating against Sterling. Whilst the value of UK plc's US real asset has appreciated, a credit position will have been built up against it and in favour of the bank under the swap.
This would be reflected initially in an increased margin deducted from sterling LIBOR. Eventually the exposure might result in becoming a "large exposure" in the central banks eyes with respect to a transaction with a small bank. A credit line greater than 10% of a bank's capital base is uncomfortably large whilst over 25% is impossibly large.
A termination by the bank for credit reasons should not give rise to a major problem for UK plc. A Capital Gains Tax loss would be generated which could be used within UK plc against Capital Gains Tax gains or carried forward within the company. Note that, whilst a funding requirement might result in a cash outflow, under a longer term swap the bank would have assumed the worst possible outcome over the period and calculated the credit line accordingly. There is no point paying for a credit line unless it is needed. Material adverse change clauses can be quite useful to banks.
No novation clause
* There is no novation agreement within the swap. The structure through leakage by corporate customers and staff moving from bank to bank soon became common knowledge. With the novelty of the structure gone, the bank should be prepared to novate all or part of the Perpetual swap to another bank with an appetite for the credit risk. This would avoid a cash flow or tax event for UK plc under current tax legislation.
Hedged investment disposal
* Termination could occur as a result of UK plc's requirements. The US subsidiary could have been disposed of. The currency gain or loss under the real asset would need to be offset by a loss or gain under the swap.
In general, however, the swap would be terminated at the same time as the real asset was sold and not at the annual payment date. A provision to terminate the swap within a roll-over period should be included in the terms of the Perpetual Swap.
* UK plc wishes to generate a Capital Gains Tax gain or loss under the Perpetual Swap as part of its tax management. It could create a Capital Gains Tax gain to offset Capital Gains Tax losses incurred in the current year or carried forward from previous years within UK plc. A Capital Gains Tax Loss generated to offset other Capital Gains Tax gains within UK plc would also free up bank lines.
A new Perpetual Swap would be effected simultaneously to maintain the hedge.
There were a number of advantages to this translation exposure management structure. These include:
Disadvantages were the bank's right to terminate and the variability of the margin quoted by it.
Balance Sheet reduction
The standard method of hedging translation exposure is to use foreign currency borrowing.
But why borrow if there is no need for external funds? The Perpetual or any off balance sheet hedge eliminates the need for funding in the currency of investment. It allows the use of funds held on deposit in Sterling or a Sterling rights issue. If financing is indeed needed it can be sourced through the medium and currency which most highly rates UK plc and therefore provides it with the lowest price.
Increased borrowing solely for hedging purposes might also impact on gearing covenants.
Under the then UK tax system, long since change, exchange differences on capital borrowing were generally not recognised for tax purposes. The disposal of the capital asset, i.e. the US subsidiary, and the sale of the dollar proceeds at spot fell under Capital Gains Tax. There would not, therefore, be matching for tax purposes by an exchange loss under a capital borrowing.
Forward disposals of foreign currency through forward contracts or currency swaps also came under the scope of Capital Gains Tax.
Hedging through forward contracts, however, represented unconditional disposals of the foreign currency as at their inception dates for Capital Gains Tax purposes. A sale of Dollars under a long term currency swap would also represent an unconditional Capital Gains Tax disposal as at its inception date (unless a suitable conditionality clause was installed). This would not only result in a timing mismatch but also the books would have to be kept open for some years with possible tax penalties.
The perpetual swap represented a conditional contract. Remember both parties had the right to terminate. The date of disposal of the currency was not known at the outset. The perpetual currency swap incorporated a cross option whereby either party can determine when the currencies are to be exchanged. For Capital Gains Tax purposes, therefore, the disposal of currency takes place when the currencies are exchanged unconditionally; i.e. on the termination date.
The swap should be made available in most currency pairs. The swap is derived from the foreign exchange swap market. In fact, the Perpetual is hedged by the bank through a series of forwards. So long as a Forex forward exists in the currencies the Perpetual swap can be structured.
Unlike the cross currency interest rate swap market, the Forex forward swap market is liquid even in minor currencies (subject to exchange controls).
The hedge will have to be terminated in the event of the asset disposal. Long term forward contracts or currency swaps are difficult to unwind. A forward contract is, effectively, a, cross currency, zero coupon fixed/fixed interest rate swap. Volatility of interest rate differentials would result in a loss or gain on disposal under such a hedge. On the other hand, the Perpetual swap, which is a floating/floating swap, is relatively stable in the same way as a floating rate note is stable.
Pricing of a product derived from the Forex market should be competitive. By contrast, the medium to long term currency swap market is expensive. Unwinding costs are minimised under the Perpetual.
Under the example, UK plc should have a good idea of a reasonable margin by obtaining quotes from the foreign exchange forward market. Given that the cross currency LIBORs do not exactly derive the Forex forwards, the margin will vary.
By maintaining the ability to terminate the swap within a year, the bank was able to regard the swap as a one year transaction.
Under central bank rules, currency forwards and swaps required a capital backing of the mark-to-market value plus 1 per cent for transactions of up to one year of outstanding term or plus 5 per cent for outstanding terms of over one year.
This therefore led mechanically to a lower price relative to long term swaps. This was simply on the basis of regulatory requirements regulatory arbitrage.
Credit line efficiency
Credit considerations are similar to but not identical to capital constraints.
A bank credit-analysing a five year currency swap would look at the worst (95 per cent) case over the period and require a credit line of 40 per cent to 50 per cent of the notional principal amount. A one year horizon would have required a line of 10 per cent to 20 per cent. Credit lines would only be utilised if rates actually moved rather than by looking at worst case scenarios.
The UK taxation rules changed soon. In March 1991 the UK Inland Revenue proposals provided for the recognition as income of exchange differences on all monetary assets and liabilities as they accrued on a translation basis.
Capital borrowing was no longer be treated as a "nothing" but got income treatment. Swaps and forwards will also be treated as monetary items and therefore any gain or loss on unwinding will be treated as income rather than suffer Capital Gains Tax. There will be no provision to match a hedge to the underlying asset or liability. Furthermore, the income treatment would apply on a translation basis; i.e. marked to market every year.
Hedging a capital asset, such as a US subsidiary through the use of Forex forwards swaps or borrowing would amount to a capital asset being hedged by a "monetary liability" and generate a tax mismatch.
The Revenue wrote that: "All monetary assets and liabilities whose treatment would be affected by the new scheme would be valued on the day the scheme came into operation. Any exchange differences arising subsequently would be calculated for tax purposes by reference to that valuation". Existing Perpetual swaps, unlike true long term arrangements, could have been terminated on the introduction of revised taxation rules.
The perpetual, capital-hedging, callable, revolving or cancellable swap was a typical financial instrument engineered to overcome the perceived inconsistencies of the tax system. But tax management is a moving target. No sooner has a solution to a problem been created but the problem disappears or is transformed into quite a different one. Financial engineers soon structured products in line with the Inland revenues new rules. Nevertheless, whereas the modern marketing manager claims not to sell products but provide tailor-made solutions, the perpetual currency swap product which lost its original rationale soon found other uses. It efficient pricing mechanism remained. It was an ideal and efficient product for the currency hedging of investment funds.
This second case study on the Perpetual currency swap also illustrates tax benefits. In no sense would I regard myself as a tax authority. But in highly competitive markets and inconsistent tax treatments focusing on solving taxation problems rather than fractions of a basis point was a far better return on time and effort invested. This product also featured regulatory arbitrage in that pricing was determined by the arbitrariness of capital adequacy rules which rose significantly on structured with maturities greater than one year.
Another lesson from the Perpetual is the lack of proprietary rights over the structure. Now, however, at the turn of the millennium, business processes can be patented.
Finally, the Perpetual currency swaps development illustrates, just as the creation of the Break Forward shows, the tangible benefits in cross-disciplinary teams whether formal or virtual. These products were developed a decade before Knowledge management became fashionable in management consulting.