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Interest Rate & Currency Swaps

INTERNATIONAL FINANCIAL MANAGEMENT


Fourth Edition EUN / RESNICK

Chapter Objective:

INTERNATIONAL FINANCIAL MANAGEMENT

Chapter Fourteen

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This chapter discusses currency and interest rate swaps, which are relatively new instruments for Fourth Edition hedging long-term interest rate risk and foreign EUN / RESNICK exchange risk.
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Chapter Outline
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Definitions
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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?
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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:
n

Single currency interest rate swap


u Plain vanilla fixed-for-floating swaps are often just called

interest rate swaps .


n

Cross-Currency interest rate swap


uThis is often called a currency swap ;

fixed for fixed rate debt

service in two (or more) currencies.


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Size of the Swap Market


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The Swap Bank


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In 2004 the notational principal of:


Interest rate swaps was $127,570 billion USD. Currency swaps was $7,033 billion USD

The most popular currencies are:


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

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.
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Swap Market Quotations


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Interest Rate Swap Quotations


Euro-
Bid 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year 2.34 2.62 2.86 3.06 3.23 3.38 3.52 3.63 3.74 3.82 Ask 2.37

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.

Sterling
Bid 5.21 Ask 5.22

Swiss franc
Bid 0.92 Ask 0.98 1.31

U.S. $
Bid 3.54 3.90 Ask 3.57 3.94

2.65 5.14 5.18 1.23 2.89 3.823.85 means1.50 5.13 5.17 the

1.58 4.11 4.13 swap bank will pay 3.09 fixed-rate5.17 payments at 3.82% 5.12 4.25 4.28 euro 1.73 1.81 3.26 against receiving1.93 LIBOR or it will 5.11 5.16 4.37 4.39 euro 2.01 3.41 receive fixed-rate euro payments at 4.50 5.11 5.16 2.10 2.18 4.46 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

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An Example of an Interest Rate Swap


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An Example of an Interest Rate Swap


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Consider this example of a plain vanilla interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.
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Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.
n n

Bank A is considering issuing 5 -year fixed-rate Eurodollar bonds at 10 percent. It would make more sense to for the bank to issue floating -rate notes at LIBOR to finance floating -rate Eurodollar loans.
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Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5year floating-rate notes at LIBOR + percent. Firm B would prefer to borrow at a fixed rate.
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An Example of an Interest Rate Swap


The borrowing opportunities of the two firms are:
Company B Fixed rate Floating rate 11.75% LIBOR + .5% Bank A 10% LIBOR

An Example of an Interest Rate Swap


Swap
10 3/8%

Bank

LIBOR 1/8%

Bank A
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B

The swap bank makes this offer to Bank A: You pay LIBOR 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years
BANK A 10% LIBOR

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An Example of an Interest Rate Swap


% of $10,000,000 = $50,000. Thats quite a cost savings per year 10 3/8% for 5 years.

An Example of an Interest Rate Swap


The swap bank makes this offer to company B: You pay us 10% per year on $10 million for 5 years and we will pay you LIBOR % per year on $10 million for 5 years.
Fixed rate Floating rate

Swap Bank

Heres whats in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR 1/8) = LIBOR % which is % better than they can borrow floating without a swap.

Swap Bank
10 % LIBOR %

LIBOR 1/8%

Bank
10%

Company B
COMPANY 11.75% LIBOR + .5% B BANK A 10% LIBOR

A
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B

BANK A 10% LIBOR

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An Example of an Interest Rate Swap


Heres whats in it for B:
They can borrow externally at LIBOR + % and have a net borrowing position of 10 + (LIBOR + ) - (LIBOR - ) = 11.25% which is % better than they can borrow floating.
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B BANK A 10% LIBOR

An Example of an Interest Rate Swap


The swap bank makes money too.
10 3/8%

Swap Bank

% of $10,000,000 = $50,000 thats quite a cost savings per year for 5 years. 10 %
LIBOR %

Swap Bank

% of $10 million = $25,000 per year for 5 years.


10 % LIBOR %

LIBOR 1/8%

Company B

LIBOR + %

Bank A

LIBOR 1/8 [LIBOR ]= 1/8 10 - 10 3/8 = 1/8


COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B

Company B

BANK A 10% LIBOR

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An Example of an Interest Rate Swap


The swap bank makes % Swap
10 3/8%

An Example of a Currency Swap


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Bank
10 % LIBOR %

LIBOR 1/8%

Bank A A saves %
Fixed rate Floating rate

Company B
COMPANY 11.75% LIBOR + .5% B BANK A 10% LIBOR

Suppose a U.S. MNC wants to finance a 10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.
n

B saves %
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This will give them exchange rate risk: financing a sterling project with dollars.

They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.
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An Example of a Currency Swap


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An Example of a Currency Swap


Consider two firms A and B: firm A is a U.S.based multinational and firm B is a U.K.based multinational. Both firms wish to finance a project in each others country of the same size. Their borrowing opportunities are given in the table below.
$ Company A Company B 8.0% 10.0% 11.6% 12.0%

If they can find a British MNC with a mirrorimage financing need they may both benefit from a swap. If the spot exchange rate is S0($/) = $1.60/, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

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An Example of a Currency Swap


Swap Bank
$8% 11% $8% $9.4% 12%

An Example of a Currency Swap


As net position is to borrow at 11%
$8% 11%

Swap Bank
$9.4% 12%

Firm A
$ Company A Company B 8.0% 10.0% 11.6% 12.0%

Firm B

12%

$8%

Firm A A saves .6%


$ Company A Company B 8.0% 10.0% 11.6% 12.0%

Firm B

12%

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An Example of a Currency Swap


B s net position is to borrow at $9.4%
$8% 11% $8%

An Example of a Currency Swap


The swap bank makes money too: Swap Bank
11%

Swap Bank
$9.4% 12%

$8%

1.4% of $16 million financed with 1% of 10 million per year $9.4% for 5 years.
12%

Firm A
$ Company A Company B 8.0% 10.0% 11.6% 12.0%

Firm B

12%

$8%

Firm

B saves $.6%

$224,000 $160,000 $64,000


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Firm 12% At S0($/) = $1.60/, that is a gain of $64,000 per A B year for 5 years. The swap bank faces $ exchange rate risk, Company A 8 . 0 % 11.6% but maybe they can Company B 1 0 . 0 % 12.0% lay it off (in another swap).
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The QSD
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Comparative Advantage as the Basis for Swaps


A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B A pays .4% less to borrow in pounds than B:
$ Company A Company B 8.0% 10.0% 11.6% 12.0%

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. In the above example, company B is less creditworthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.
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A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds.
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Comparative Advantage as the Basis for Swaps


B has a comparative advantage in borrowing in . B pays 2% more to borrow in dollars than A
$ Company A Company B 8.0% 10.0% 11.6% 12.0%

Comparative Advantage as the Basis for Swaps


A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. If they borrow according to their comparative advantage and then swap, there will be gains for both parties.
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B pays only .4% more to borrow in pounds than A:


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Variations of Basic Currency and Interest Rate Swaps


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Risks of Interest Rate and Currency Swaps


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Currency Swaps
n n n n

Interest Rate Risk


n

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

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.
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Basis Risk
n

Interest Rate Swaps


n n

Exchange rate Risk


n

For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.
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Risks of Interest Rate and Currency Swaps (continued)


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Pricing a Swap
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Credit Risk
n

This is the major risk faced by a swap dealerthe risk that a counter party will default on its end of the swap. It s 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.
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Mismatch Risk
n

A swap is a derivative security so it can be priced in terms of the underlying assets: How to:
n

Sovereign Risk
n

Any swaps value is the difference in the present values of the payment streams that are incoming and outgoing. Plain vanilla fixed for floating swaps get valued just like a pair of bonds. Currency swap gets valued just like two nests of currency forward contracts.
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Swap Market Efficiency


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Concluding Remarks
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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.
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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

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End Chapter Fourteen

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