The ups and downs of foreign exchange are one of the risks which American firms must accept if they manufacture or sell products abroad, but there are prudent ways to minimize it. One device which has proved effective as a hedge against losses, is the currency swap. Here is how it works in Brazil where private U. S. firms, using a combination spot and futures agreement, swap dollars for cruzeiros with the Bank of Brazil, and, a year later, swap the cruzeiros back for dollars at a guaranteed rate.
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References
1.
EinzigPaul, Theory of Forward Exchange (London: Macmillan and Company, Ltd., 1961), p. 18.
2.
See note 1, p. 338.
3.
The spread between the spot buying and selling price for foreign exchange—that is, the broker's commission—is ignored.
4.
Whether the investment is actually liquidated, or whether the dollars are repurchased with cruzeiros obtained from another source, an evaluation of the success of the swap obliges one to liquidate the cruzeiro investment “in theory” if not in fact.
5.
Customarily the Bank of Brazil has charged interest on the cruzeiros it has swapped for dollars. However the interest charged is seldom in excess of 4 percent, and is usually less. As the cruzeiro deteriorates during the investment period the dollar value of the cruzeiro interest charge shrinks. The net effect of these factors is to reduce the effective cost which can be attributed to interest charged on the cruzeiro loan to between one percent and three percent. This charge will be ignored in the development outlined in the text. Note that in both Expression (I) and (II) interest has been deducted. Expressions (I) and (II), therefore, represent net gain.
6.
The Bank of Brazil could have made the swap less attractive by charging a high cruzeiro interest on its cruzeiro loan. But the Bank of Brazil's chief interest in swapping is to obtain needed dollar credits for its own use; for this purpose these swap rates serve nicely.
7.
Some may be tempted to quarrel with the argument embodied in this development on the grounds that it makes possible a net loss in excess of the cost of money on an investment whose principal is “guaranteed” (i.e., secured by the swap). It should be noted, however, that the percentage loss we have discussed is the percentage loss on the dollar value (i.e., the “real” value) of the cruzeiro investment. The American investor may argue that he thinks only in terms of dollars, and since his dollars are securely hedged his maximum possible percentage loss is the interest rate on his dollars. But the subsidiary in Brazil cannot think only in terms of dollars. Its investment opportunity is a “cruzeiro-generating” investment opportunity, not a “dollar-generating” investment opportunity. It is an investment for which cruzeiros, rather than dollars, might more appropriately be borrowed. For evaluating the choice between investing with borrowed cruzeiros versus cruzeiros purchased with borrowed dollars, and the choice between swapping versus not swapping the borrowed dollars, the subsidiary in Brazil, like the Brazilian national firm with which it competes, should consider the real value percentage gain or loss anticipated from its cruzeiro investment. Basically the logic is the same as that employed in estimating percentage gain from trading on the equity.
8.
As stated by the Brazilian Minister of Finance and reported in the Sao Paulo newsletter of the American Chamber of Commerce for Brazil, October 19, 1959.
9.
Summary Proceedings of the September meeting of the Board of Governors of the International Monetary Fund, Washington, D.C., 1960, p. 62.
