INTERNATIONAL FINANCIAL MANAGEMENT

Fifth Edition EUN / RESNICK

McGraw-Hill/Irwin

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

Interest Rate and Currency Swaps

Chapter Objective:

Chapter Fourteen

14

This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk.
14-1

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 Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient?
14-2

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.
This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

Cross-Currency interest rate swap

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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:

14-4

U.S. dollar Japanese yen Euro Swiss franc British pound sterling

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.

14-5

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 bidask spread.

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

Interest Rate Swap Quotations

Euro-
Bid 1 year 2.34 Ask 2.37

Sterling
Bid 5.21 Ask 5.22

Swiss franc
Bid 0.92 Ask 0.98

U.S. $
Bid 3.54 Ask 3.57

2 year
3 year 4 year 5 year

2.62
2.86 3.06 3.23

2.65

5.14

5.18

1.23

1.31

3.90

3.94

2.89 3.823.855.17 5.13 means 1.50 the

6 year
7 year 8 year 9 year 10 year
14-7

3.38
3.52 3.63 3.74 3.82

1.58 swap bank4.11 pay will 4.13 3.09 fixed-rate5.17 payments at 3.82% 5.12 4.25 4.28 euro 1.73 1.81 3.26 against receiving 1.93 LIBOR or it will 5.11 5.16 4.37 4.39 euro 2.01 3.41 receive fixed-rate euro payments at 5.11 5.16 2.10 2.18 4.46 4.50 3.55 3.85% against receiving2.33 LIBOR 4.58 5.10 5.15 2.25 euro 4.55 3.66 3.77 3.85 5.10 5.09 5.08 5.15 5.14 5.13 2.37 4.48 2.56 2.45 2.56 2.64 4.62 4.70 4.75 4.66 4.72 4.79

Swap Quotations
3.823.85 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

Firm B

3.85%

$LIBOR

Swap Bank

3.82%

$LIBOR

Firm A

While most swaps are quoted against flat dollar LIBOR, off-market swaps are available where one party pays LIBOR plus or minus some number.
14-8

Example of an Interest Rate Swap

Consider firms A and B; each firm wants to borrow $40 million for 3 years.
Fixed A B 5% Floating LIBOR

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 5.15.2 against dollar LIBOR for a 3-year swap.
14-9

Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank

If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.15.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR 0.10%

Bank X
14-10

As all-in-cost: = 5.0% + LIBOR 5.10% = LIBOR 0.10%

Example of an Interest Rate Swap

Swap Bank
5.20%

Firm B LIBOR

If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.15.2 they can convert their floating rate debt into a fixed rate debt at 5.40% Bs all-in-cost: = LIBOR + LIBOR + 0.20% + 5.20% = 5.40%
14-11

Bank Y

Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank
5.20%

Firm B LIBOR

The Swap Bank makes 10 basis points on the deal: The Swap Banks all-in-cost:

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

14-12

Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank
5.20%

Firm B LIBOR

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

Bank X
14-13

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.

Bank Y

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

14-14

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.

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

Firm A Swap Bank Firm B

Bank X
14-16

Bank Y

Cash Flows of an Interest-Only Swap: T = 1

Assume LIBOR = 3%

Firm A

$2,040,000 $1,200,000

Swap Bank

$2,080,000

Firm B $1,200,000

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

Bank X
14-17

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

Bank Y

Cash Flows of an Interest-Only Swap: T = 2

Assume LIBOR = 4%

Firm A

$2,040,000 $1,600,000

Swap Bank

$2,080,000

Firm B $1,600,000

Swap Bank earns $40,000 per year. A saves $40,000 per year relative to borrowing at LIBOR = 4%.

Bank X
14-18

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

Bank Y

Cash Flows of an Interest-Only Swap: T = 3

Assume LIBOR = 5%

Firm A

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

Swap Bank

$2,080,000

Firm B $2,000,000

Swap Bank earns $40,000 per year. A saves $40,000 per year relative to borrowing at LIBOR = 4%.

Bank X
14-19

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

Bank Y

Example of an Currency Swap

$ Firm A is a U.S. MNC and wants to borrow 40 million for 3 years. A $7% 6% Firm B is a French MNC and wants to B $8% 5% borrow $60 million for 3 years 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 = 1.00
14-20

Example of a Currency Swap

Suppose

that the Swap Bank publishes these quotes. The convention is to quote against U.S. dollar LIBOR.

Euro-

U.S. $

Bid Ask 3 year 5.00 5.20

Bid 7.00

Ask 7.20

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.
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$ A $7% B $8%

6% 5%

Example of a Currency Swap

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

Euro-

U.S. $

$ A $7%
B $8%

6%
5%

Bid Ask 5.00 5.20

Bid 7.00

Ask 7.20 $7.0%

$60m

LIBOR

Bank X

Firm A
40m
$60m

$7.0% 5.2% LIBOR

Swap Bank

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

Firm A then enters in to 2 fixed for floating swaps. 14-22

FOREX Market

Example of a Currency Swap

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

Euro-

U.S. $

$ A $7%
B $8%

6%
5%

Bid Ask 5.00 5.20

LIBOR

Bid 7.00

Ask 7.20 40m

5%

Swap Bank

$7.2% 5.0% LIBOR

Firm B
$60m 40m

Bank Y

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

FOREX Market Firm B then enters in to 2

14-23

fixed for floating swaps.

Example of a Currency Swap

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

Firm A

$7.0% 5.2%

Swap Bank

$7.2%

Firm B 5.0%

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

Bank X
14-24

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.

Bank Y

Cash Flows of the Swaps: T = 0

Firm A Swap Bank Firm B

Bank X
14-25

Foreign Exchange Spot Market

Bank Y

Cash Flows of the Swaps: T = 1

Assume LIBOR = 3% $1.8m $1.8m

Firm A

$4.2m 2.08m $1.8m

Swap Bank

$4.32m 2m $1.8m

Firm B

Bank X
14-26

Swap bank earns 80,000 + $120,000 or .00240m + .002$60m per year. Firm As all-in-cost 2.08m or 5.2% of 40m Firm Bs all-in-cost $4.32 or 7.2% of $60m

Bank Y

Cash Flows of the Swaps: T = 2

Assume LIBOR = 4% $2.4m $2.4m

Firm A

$4.2m 2.08m $2.4m

Swap Bank

$4.32m 2m $2.4m

Firm B

Bank X
14-27

Bank Y

Cash Flows of the Swaps: T = 3

Assume LIBOR = 5% $3m $3m $4.2m 2.08m $3m $4.32m 2m $3m

Firm A

Swap Bank

Firm B

Bank X
14-28

Bank Y

Foreign Exchange Forward Market

Example of a Direct Currency Swap

If firms A and B knew and trusted each other, they could theoretically cut out the swap bank: $7.0% Firm Firm
$ A $7% B $8% 6% 5%

5.0%

Bank X
14-29

The problem is of course that the swap bank is acting as a broker (or even a dealer) and providing a servicethats why they get paid. Signing 1 contract is less work than 4.

Bank Y

Equivalency of Currency Swap A Debt Service Obligations

$ $7%

6% 5%

B $8%

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. (1 + i$)t According to IRP: St($/) = S0($/) (1 + i)t

$1.50(1.07)1 $1.5286 S1($/) = 1.00(1.05)1 = 1.00

14-30

IRR 7.00% 5.00%

0 $60.00 40.00

1 $4.20 2.75

2 $4.20 2.70

3 $64.20 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. 1.00 1.00(1.05) 40m = $60m 2.7477m = $4.20m $1.50 $1.50(1.07)
1.00(1.05)2 2.6963m = $4.20m $1.50(1.07)2 1.00(1.05)3 40.4446m = $64.20m $1.50(1.07)3
14-31

IRR 5.00% 7.00%

0 40.00 $60.00

1 2.00 $3.06

2 2.00 $3.12

3 42.00 $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. $1.50 $1.50(1.07) $60m = 40m $3.06m = 2m 1.00 1.00(1.05)
$1.50(1.07)2 $3.12m = 2m 1.00(1.05)2 $1.50(1.07)3 $66.67m = 42m 1.00(1.05)3
14-32

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 5.00 5.20

Bid 7.00

Ask 7.20

Competition from other swap banks will keep their spreads from getting too widethe theoretical limit is 200 basis points total. (See QSD on next 14-33 slide.)

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. $ The QSD is calculated as the difference A $7% 6% B $8% 5% between the differences.
QSD 1% 1% = 2%

14-34

Comparative Advantage as the Basis for Swaps

A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in euro. $
A $7%
B $8%

6%
5%

14-35

Variations of Basic Currency and Interest Rate Swaps

Currency Swaps

fixed for fixed fixed for floating floating for floating amortizing zero-for floating floating for floating

Interest Rate Swaps

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

14-36

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. If the floating rates of the two counterparties are not pegged to the same index. In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Basis Risk

Exchange rate Risk

14-37

Risks of Interest Rate and Currency Swaps (continued)

Credit Risk

This is the major risk faced by a swap dealerthe risk that a counter party will default on its end of the swap. Its hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

Mismatch Risk

Sovereign Risk

14-38

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.

14-39

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

14-40

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 can borrow at 9% fixed B can borrow at LIBOR + % B prefers to borrow fixed

B is a less-credit-worthy firm

Fixed Floating A 8% LIBOR B 9% LIBOR +

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.

14-41

Step 2: We are to quote the swap against flat LIBOR Step 4: check our work Step 3: The QSD = so we have 50 bp to As all-in-cost: distribute among 3 LIBOR 0.2 players. Lets try 20 forLIBOR LIBOR Bs all-in-cost: (Step 2) A and B, (Step 2) 8.8% (this leaves 10 bp Swap Bank Profit: for the swap bank) 8.2% 8.3% 10 basis points (Step 3)

Swap Bank

(Step 1)

8%

(Step 1)

LIBOR +
Step 1: A is better at borrowing fixed; B is better at borrowing floating so have them borrow externally according to their comparative advantage
Fixed A 8% B 9%
QSD = 1%

Outside Lender

Floating LIBOR LIBOR +

% = %

Outside Lender

X
14-42

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 has already borrowed in dollars at $8% 5 years ago they issued a 15-year bond B now prefers to borrow in euro but faces 6% cost

B is an American firm

Both firms want a 10-year maturity Devise a feasible swap that eliminates exchange rate risk for A and B

Step 2: We are to eliminate exchange rate risk for A and B Step 4: check our work Step 3: The QSD = so As all-in-cost: we have 50 bp to distribute $7.8% among 3 players. Lets try Bs all-in-cost: $8% 5% 20 for A and B, 5.8% (Step 2) (Step 2) Swap Bank Profit: 10 basis points at (this leaves 10 bp $7.8% 5.8% current exchange rate for the swap bank) (Step 3)

Swap Bank

(Step 1)

5%
Step 1: A is better at borrowing ; B is better at borrowing $

(Step 1)

$8%

Outside LenderX

so have them borrow externally according to their comparative advantage

Outside LenderY

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