14 interest rate and currency swaps

INTERNATIONALFINANCIAL

MANAGEMENT

EUN / RESNICK

Fifth Edition

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter Objective:

This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk.

14Chapter Fourteen

Interest Rate and Currency Swaps

14-2

Chapter Outline

Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient?











14-3

Definitions

In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.

There are two types of interest rate swaps: Single currency interest rate swap

“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.

Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed rate debt

service in two (or more) currencies.

14-4

Size of the Swap Market

In 2007 the notational principal of:Interest rate swaps was $271.9 trillion USD.

Currency swaps was $12 trillion USD

The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling

14-5

The Swap Bank

A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.

The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but

does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either

side of a currency swap, and then later lay off their risk, or match it with a counterparty.

14-6

Swap Market Quotations

Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs

They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

14-7

Interest Rate Swap QuotationsEuro-€ £ Sterling Swiss franc U.S. $

Bid Ask Bid Ask Bid Ask Bid Ask

1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57

2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94

3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13

4 year 3.06 3.09 5.12 5.17 1.73 1.81 4.25 4.28

5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39

6 year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50

7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58

8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66

9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72

10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79

3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR

The convention is to quote against U.S. dollar LIBOR.

14-8

Swap Quotations

3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR

Swap Bank

Firm A

Firm B

€3.82%€3.85%

$LIBOR $LIBOR

While most swaps are quoted against “flat” dollar LIBOR, “off-market” swaps are available where one party pays LIBOR plus or minus some number.

14-9

Example of an Interest Rate SwapConsider firms A and B; each firm wants to borrow $40 million for 3 years.

Fixed Floating

A 5% LIBOR

B 5.50% LIBOR + .20%

Firm A wants finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate.

A has good credit and can borrow at LIBOR

Firm B wants finance an interest-rate-insensitive asset and therefore wants to borrow at a fixed rate.

B has less-than-perfect credit and can borrow at 5.5%

The swap bank quotes 5.1—5.2 against dollar LIBOR for a 3-year swap.

14-10

Example of an Interest Rate Swap

Firm A

5.10%

LIBOR

Bank X

Swap Bank

5.0% If Firm A borrows from their bank at 5.0% fixed

and takes up the swap bank on their offer of 5.1—5.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR – 0.10%

A’s all-in-cost:

= 5.0% + LIBOR – 5.10% = LIBOR – 0.10% 14-11


Firm B

5.20%

Bank Y

Swap Bank LIBOR

LIBOR + .2%

If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.1—5.2 they can convert their floating rate debt into a fixed rate debt at 5.40%

B’s all-in-cost:

= –LIBOR + LIBOR + 0.20% + 5.20% = 5.40% 14-12


Firm B

Firm A

5.20%5.10%

LIBOR

Swap Bank LIBOR

The Swap Bank makes 10 basis points on the deal:

The Swap Bank’s all-in-cost:

= –LIBOR + LIBOR – 5.20% + 5.10% = –0.10%

14-13


Firm B

Firm A

5.20%5.10%

Bank X

Bank Y

Swap BankLIBOR LIBOR

5.0%

LIBOR + .2%

The notional size is $40 million.The tenor is for 3 years.

A earns $40,000 per year on the swap.

B earns $40,000 per year on the swap.Swap Bank earns $40,000 per year.

14-14

Using a Swap to Transform a Liability

Firm A has transformed a fixed rate liability into a floater. A is borrowing at LIBOR – .10% A savings of 10 bp

Firm B has transformed a floating rate liability into a fixed rate liability. B is borrowing at 5.40% A savings of 10 bp

14-15

What about the Principal?

In our “plain vanilla” interest-only interest rate swap just given, we did not mention swapping the Notational Principal.

It could be the case that firm A exchanged principal with their lender (Bank X) and firm B exchanged principal with their outside lender, Bank Y.

14-16

Cash Flows of an Interest-Only Swap: T = 0

Firm B

Firm A

Bank X

Bank Y

Swap Bank

$40,

000,

000 $40,000,000

14-17


Firm B

Firm A

Bank X

Bank Y

Swap Bank

$2,0

00,0

00$1,280,000

Assume LIBOR = 3%

$1,200,000 $1,200,000

$2,040,000 $2,080,000

A saves $40,000 per year relative to borrowing at LIBOR = 3%.

B saves $40,000 per year relative to borrowing at 5.5%.

Swap Bank earns $40,000 per year.

14-18


$1,600,000

Firm B

Firm A

$2,040,000

Bank X

Bank Y

Swap Bank

$2,0

00,0

00$1,680,000

Assume LIBOR = 4%

$1,600,000

$2,080,000




14-19


$2,000,000

Firm B

Firm A

$2,040,000

Bank X

Bank Y

Swap Bank

$42

,000

,000

$42,080,000

Assume LIBOR = 5%

$2,000,000

$2,080,000




14-20

Example of an Currency SwapFirm A is a U.S. MNC and wants to borrow €40 million for 3 years.

Firm B is a French MNC and wants to borrow $60 million for 3 years

$ €

A $7% €6%

B $8% €5%

Firm A wants finance euro denominated asset in Italy and therefore wants to borrow euro.

A can borrow euro at 6%

Firm B wants finance a dollar denominated asset and therefore wants to borrow dollars.

B can borrow dollars at 8%

The current exchange rate is $1.50 = €1.0014-21

Example of a Currency Swap

Euro-€ U.S. $

Bid Ask Bid Ask

3 year 5.00 5.20 7.00 7.20

Suppose that the Swap Bank publishes these quotes.

The convention is to quote against U.S. dollar LIBOR.

$ €

A $7% €6%

B $8% €5%

Firm A wants finance euro-denominated asset in Italy and wants to borrow euro.

A can borrow euro at 6% or they can borrow euro at 5.2% by using a currency swap.

14-22

$7.0%


Euro-€ U.S. $

Bid Ask Bid Ask

5.00 5.20 7.00 7.20

$ €

A $7% €6%

B $8% €5%

Suppose that Firm A borrows $60m at $7%; trades for € at spot.

Firm A €5.2%

Swap Bank

Bank X

FOREX Market

LIBOR

LIBOR

$7.0%

(The convention is to quote against U.S. dollar LIBOR.)

$60m$60m €4

0mFirm A then enters in to 2 fixed for floating swaps.

14-23

$7.2%


Euro-€ U.S. $

Bid Ask Bid Ask

5.00 5.20 7.00 7.20

$ €

A $7% €6%

B $8% €5%

Suppose that Firm B borrows €40m at €5%, trades for $.

Firm B€5.0%

Bank Y

Swap Bank

FOREX Market

LIBOR

LIBOR

€40m

(The convention is to quote against U.S. dollar LIBOR.)

€5%

€40m $60m

Firm B then enters in to 2 fixed for floating swaps.

14-24


Firm B

Firm A

$7.0% $7.2%

€5.2%

Bank X

Bank Y

Swap Bank €5.0%

$7.0

% €5.0%

The notional size is $60m.The tenor is for 3 years.

Firm A earns 80 bp per year on the swap and hedges exchange rate risk.

Firm B earns 80 bp per year on the swap and hedges exchange rate risk.

Swap Bank earns 40 bp per year (20bp in $ and 20bp in €).

14-25

Cash Flows of the Swaps: T = 0

Firm B

Firm A

Bank X

Bank Y

Swap Bank

$60,

000,

000 €40,000,000

Foreign Exchange Spot Market€40,000,000

$60,

000,

000

€40,

000,

000$60,000,000

14-26


Firm B

Firm A

Swap Bank

$4.32m

€2m

$1.8m

$1.8m

$4.2m

€2.08m

$1.8m

$1.8m

Bank X

Bank Y

Assume LIBOR = 3%

$4.2m

€2m

Firm A’s all-in-cost €2.08m or

5.2% of €40m

Firm B’s all-in-cost $4.32 or

7.2% of $60m

Swap bank earns €80,000 + $120,000 or .002×€40m + .002×$60m per year.

14-27


Firm B

Firm A

Swap Bank

$4.32m

€2m

$2.4m

$2.4m

$4.2m

€2.08m

$2.4m

$2.4m

Bank X

Bank Y

Assume LIBOR = 4%

$4.2m

€2m

14-28


Firm B

Firm A

Swap Bank

$4.32m

€2m

$3m

$3m

$4.2m

€2.08m

$3m

$3m

Bank X

Bank Y

Assume LIBOR = 5%

$64.2

m €42m

Foreign Exchange Forward Market

$60m€4

0m$6

0m€40m

14-29

Example of a Direct Currency Swap

Firm B

Firm A

$7.0%

Bank X

Bank Y

€5.0%

$7.0

% €5.0%

The problem is of course that the swap bank is acting as a broker (or even a dealer) and providing a service—that’s why they get paid.

Signing 1 contract is less work than 4.

$ €

A $7% €6%

B $8% €5%

If firms A and B knew and trusted each other, they could theoretically cut out the swap bank:

14-30

Equivalency of Currency Swap Debt Service Obligations

We can assume that IRP holds between the €5% euro rate and the $7% dollar rate. This is reasonable since these rates are, respectively, the

best rates available for each counterparty who is well known in its national market.

According to IRP:

$ €

A $7% €6%

B $8% €5%

St($/€) = S0($/€) × (1 + i$)t

(1 + i€)t

S1($/€) =$1.50×(1.07)1

€1.00×(1.05)1

$1.5286€1.00=

14-31

IRR 0 1 2 3

7.00% –$60.00 $4.20 $4.20 $64.20

5.00% –€40.00 €2.75 €2.70 €40.44

The swap bank could borrow $60m at 7% and use a set of 3 forward contracts to redenominate their bond as a 5% euro bond.

–€40m = –$60m×€1.00$1.50 €2.7477m = $4.20m× $1.50×(1.07)

€1.00×(1.05)

€2.6963m = $4.20m× $1.50×(1.07)2

€1.00×(1.05)2

€40.4446m = $64.20m× $1.50×(1.07)3

€1.00×(1.05)3

14-32

IRR 0 1 2 3

5.00% –€40.00 €2.00 €2.00 €42.00

7.00% –$60.00 $3.06 $3.12 $66.67

The swap bank could borrow €40m at 5% and use a set of 3 forward contracts to redenominate their bond as a 7% dollar bond.

–$60m = –€40m×$1.50€1.00 $3.06m = €2m × × €1.00×(1.05)

$1.50×(1.07)

$3.12m = €2m ×× €1.00×(1.05)2

$1.50×(1.07)2

$66.67m = €42m×€1.00×(1.05)3

$1.50×(1.07)3

14-33

Equivalency of Currency Swap Debt Service Obligations

The ability to hedge with covered interest arbitrage is where the swap bank found the €5% and $7% rates

Euro-€ U.S. $

Bid Ask Bid Ask

5.00 5.20 7.00 7.20

Competition from other swap banks will keep their spreads from getting too wide—the theoretical limit is 200 basis points total. (See QSD on next slide.)14-34

The QSD

The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.

There is no reason to presume that the gains will be shared equally.

$ €

A $7% €6%

B $8% €5%

QSD 1% – –1% = 2%

The QSD is calculated as the difference

between the differences.

14-35

Comparative Advantage as the Basis for Swaps

$ €

A $7% €6%

B $8% €5%

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in euro.

14-36

Variations of Basic Currency and Interest Rate Swaps

Currency Swaps fixed for fixed fixed for floating floating for floating amortizing

Interest Rate Swaps zero-for floating floating for floating

For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

14-37

Risks of Interest Rate and Currency Swaps

Interest Rate Risk Interest rates might move against the swap bank after it

has only gotten half of a swap on the books, or if it has an unhedged position.

Basis Risk If the floating rates of the two counterparties are not

pegged to the same index. Exchange rate Risk

In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

14-38

Risks of Interest Rate and Currency Swaps (continued)

Credit Risk This is the major risk faced by a swap dealer—the risk

that a counter party will default on its end of the swap. Mismatch Risk

It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.

Sovereign Risk The risk that a country will impose exchange rate

restrictions that will interfere with performance on the swap.

14-39

Swap Market Efficiency

Swaps offer market completeness and that has accounted for their existence and growth.

Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

14-40

Concluding Remarks

The growth of the swap market has been astounding.

Swaps are off-the-books transactions. Swaps have become an important source of

revenue and risk for banks

14-41

Sample Interest Rate Swap Problem A is a credit-worthy firm

A can borrow at 8% fixed A can borrow at flat LIBOR A prefers to borrow floating

B is a less-credit-worthy firm B can borrow at 9% fixed B can borrow at LIBOR + ½% B prefers to borrow fixed

Both firms want a 10-year maturity Devise a swap that is mutually beneficial for A and B.

Follow the convention of pricing against “flat” LIBOR.

Fixed Floating

A 8% LIBOR

B 9% LIBOR + ½

14-42

A B

Swap

Bank

Outside

Lender

X

Outside

Lender

Y

Fixed Floating

A 8% LIBOR

B 9% LIBOR + ½ QSD = 1% – ½% = ½%

Step 1: A is better at borrowing fixed; B is better at borrowing floating so have them borrow externally according to their comparative advantage

Step 2: We are to quote the swap against flat LIBOR

8%(Step 1) LIBOR + ½ (Step 1)

LIBOR(Step 2)

LIBOR(Step 2)

Step 3: The QSD = ½ so we have 50 bp to distribute among 3 players. Let’s try 20 for A and B, (this leaves 10 bp for the swap bank) 8.2%

(Step 3)8.3%

Step 4: check our work

A’s all-in-cost:LIBOR – 0.2

B’s all-in-cost:8.8%

Swap Bank Profit:

10 basis points

14-43

Sample Currency Swap Problem A is an Italian firm

A can borrow in euro at €5% fixed A prefers to borrow in dollars but faces $8% cost

B is an American firm B has already borrowed in dollars at $8½% 5 years ago they issued a 15-year bond B now prefers to borrow in euro but faces €6% cost

Both firms want a 10-year maturity Devise a feasible swap that eliminates exchange

rate risk for A and B

Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A B

Swap

Bank

Outside

LenderX

Outside

LenderY

Step 1: A is better at borrowing €;

B is better at borrowing $

so have them borrow externally according to their comparative advantage

Step 2: We are to eliminate exchange rate risk for A and B

€5%(Step 1) $8½%(Step 1)

$8½%(Step 2)(Step 2)

Step 3: The QSD = ½ so we have 50 bp to distribute among 3 players. Let’s try 20 for A and B, (this leaves 10 bp for the swap bank)

$7.8%(Step 3)

€5.8%

Step 4: check our work A’s all-in-

cost:$7.8%B’s all-in-cost:€5.8%

Swap Bank Profit:

10 basis points at current

exchange rate

€5%

14 interest rate and currency swaps

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