Interest Rate and Currency SWAPS

1. Assuming that A wants a floating rate, B desires a fixed rate, design a swap deal for A and
B, in such a way that it benefits both companies, when they face the following terms
structure

Company Fixed Rate Floating Rate

A 10% MIBOR + 25bp
B 12% MIBOR + 75bp
Solution:
Difference in fixed rate market is 12 – 10 = 2%
Difference in floating rate market M + 0.75 – M + 0.25 = M + 0.50
Comparative advantage = 2.00 – M + 0.50 = 1.50%
Net benefit to each company 1.5/2 = 0.75%
Net cost to Company A = M+0.25 – 0.75 = M – 0.50
Net cost to Company B = 12 – 0.75 = 11.25%

Maximum spread is in fixed rate market hence the benefit is adjusted in fixed rate and
floating rate is kept unchanged. The same can be shown with the help of diagram as under:

Pays M + 0.75%
A B
Pays 11.25%

Pays 10% Pays M +

0.75%
Lender in Lender in
Fixed Rate Floating
Market Market
Cash Flow to Company A Cash Flow to Company B
Receives Fixed rate 11.25 Receives floating rate M + 0.75
Pays Fixed rate 10.00 Pays floating rate M + 0.75
Pays floating rate M + 0.75 Pays fixed rate 11.25
Net Rate M – 0.50 Net Rate 11.25

2. Company A and B have offered the following rates per annum on ₹200 million loan.
Company Fixed Rate Floating Rate
A 12.00% MIBOR + 0.1%
B 13.40% MIBOR + 0.6%
Company A requires floating rate loan and Company B requires fixed rate loan. Design a
swap that will net a Bank acting as intermediary 0.1% per annum and equally attractive to
both the parties. Show the diagram.

Solution:
Difference in fixed rate market is 13.4 – 12 = 1.4%
Difference in floating rate market M + 0.6 – M + 0.1 = M + 0.5
Comparative advantage = 1.4 – M + 0.5 = 0.9%
Intermediary charges 0.1%
Net benefit = 0.9% - 0.1% = 0.8%
Net benefit to each company 0.8/2 = 0.4% each
Net cost to Company A = M + 0.1 – 0.4 = M – 0.3
Net cost to Company B = 13.4 – 0.4 = 13%

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College

 Interest Rate and Currency SWAPS

Maximum spread is in fixed rate market hence the benefit is adjusted in fixed rate and
floating rate is kept unchanged. The same can be shown with the help of diagram as under:
Pays M + 0.10% Receives M + 0.6%
on ₹ 200 Mn on ₹ 200 Mn
A Bank B
Receives 12.4% Pays 13% on
on ₹ 200 Mn ₹ 200 Mn

Pays 12% Pays M + 0.6%

on ₹ 200 Mn on ₹ 200 Mn

Lender in Fixed Lender in

Rate Market on ₹ Floating Market
200 Mn on ₹ 200 Mn

Cash Flow to Company A

Receives Fixed rate 12.4
Pays Fixed rate 12.0
Pays floating rate M + 0.1
Net Rate M – 0.3

Cash Flow to Company B

Receives floating rate M + 0.6
Pays floating rate M + 0.6
Pays fixed rate 13.0
Net Rate 13.0

3. Company A and B are offered the following interest rates on a loan of ₹ 5 million by their
banks. You are required to construct an interest rate swap for these firms netting 0.5% to
the bank acting as intermediary and equally attractive by A and B. Show the swap cash
flows.

Company Fixed Rate Floating Rate

A 15% MIBOR + 2%
B 18% MIBOR + 2.5%

Solution:
Difference in fixed rate market is 18 – 15 = 3%
Difference in floating rate market M + 2.5 – M + 2 = M + 0.5
Comparative advantage = 3 – M + 0.5 = 2.5%
Intermediary charges 0.5%
Net benefit = 2.5% - 0.5% = 2%
Net benefit to each company 2/2 = 1% each
Net cost to Company A = M + 2 – 1 = M + 1%
Net cost to Company B = 18 – 1 = 17%

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College

 Interest Rate and Currency SWAPS
Maximum spread is in fixed rate market hence the benefit is adjusted in fixed rate and
floating rate is kept unchanged. The same can be shown with the help of diagram as under:

Pays M + 2.5% Receives M + 2.5%

on ₹ 5 Mn on ₹ 5 Mn
A Bank B
Receives 16.5% Pays 17 % on
on ₹ 5 Mn ₹ 5 Mn
Pays 15%
Pays M
on ₹ 5 Mn
+2.5% on ₹ 5
Mn
Lender in Lender in
Fixed Rate Floating
Market on ₹ 5 Market on ₹ 5
Mn Mn
Cash Flow to Company A Cash Flow to Company B
Receives Fixed rate 16.50 Receives Floating rate M+2.5%
Pays Fixed rate 15.00 Pays floating rate M+2.5%
Pays floating rate M + 2.5 Pays fixed rate 17%
Net Rate M + 1.0 Net Rate 17%

4. Company ABC wishes to borrow US dollars at a fixed rate of interest company XYZ
wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two
companies are the same at the current exchange rate. The companies have been quoted
the following interest rates, which have been adjusted for the impact of taxes:

Company Yen US Dollar

A 5% 9.6%
B 6.5% 10.0%

Design a swap that will net a bank, acting as intermediary, 50 basis points p.a and equally
attractive to the two companies and ensure that all the foreign exchange risk is assumed
by the bank.

Solution:
The maximum spread is existing in Yen market (6.5 – 5) 1.5% compared that of US Dollar
market i.e (10-9.6) = 0.4%. Therefore Company A will borrow from Yen market and give
to Company B. On the other hand Company B will borrow from US Dollar market and
give to Company A.

Difference in Yen market is 6.5 - 5 = 1.5%

Difference in US Dollar market 10 – 9.6 = 0.4
Comparative advantage 1.5 – 0.4 = 1.1%
Intermediary charges 0.50%
Net benefit = 1.1% - 0.5% = 0.6%
Net benefit to each company 0.6 /2 = 0.3% each
Net cost to Company A = 9.6 – 0.3= 9.3
Net cost to Company B = 6.5 – 0.3= 6.2%

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College

 Interest Rate and Currency SWAPS
Pays 9.3% in USD Receives 10% in
USD
A Bank B
Receives 5% in Pays 6.2% in Yen
Yen
Pays 5% in
Pays 10% in
Yen
USD

Lender in Lender in
Yen Market USD Market

Cash Flow to Company A

Receives on Yen 5.0
Pays on Yen 5.0
Pays on USD 9.3
Net Rate 9.3

Cash Flow to Company B

Receives USD 10.0
Pays USD 10.0
Pays Yen 6.2
Net Rate 6.2
5. Company AKR wishes to borrow U S Dollar at a fixed rate of interest. Company RAK
wishes to borrow Japanese Ye at a fixed rate of interest. The amount required by the
companies are roughly the same at current exchange rate.

Company Yen Dollar

AKR 4% 8.6
RAK 5.5% 9.0%
Design a swap that will net a bank acting as an intermediary, 50 basis points per annum.
Make the swap equally attractive to both the companies and ensure foreign exchange risk
assumed by the bank.

Solution:
The maximum spread is existing in Yen market (5.5 – 4) 1.5% compared that of Dollar
market i.e (9 - 8.6) = 0.4%. Therefore Company AKR will borrow from Yen market and
give to Company RAK. On the other hand Company RAK will borrow from Dollar market
and give to Company AKR.

Difference in Yen market is 5.5 - 4 = 1.5%

Difference in US Dollar market 9 – 8.6 = 0.4
Comparative advantage 1.5 – 0.4 = 1.1%
Intermediary charges 0.50%
Net benefit = 1.1% - 0.5% = 0.6%
Net benefit to each company 0.6 /2 = 0.3% each
Net cost to Company AKR = 8.6 – 0.3= 8.3
Net cost to Company RAK = 5.5 – 0.3= 5.2%

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College

 Interest Rate and Currency SWAPS
Pays 8.3% in USD Receives 9% in USD
A Bank B
Receives 4% in Yen Pays 5.2% in Yen

Pays 4% in
Pays 9% in
Yen
USD

Lender in Lender in
Yen Market USD Market

Cash Flow to Company A Cash Flow to Company B

Receives on Yen 4.0 Receives USD 9.0
Pays on Yen 4.0 Pays USD 9.0
Pays on USD 8.3 Pays Yen 5.2
Net Rate 98.3 Net Rate 5.2

6. Company XYZ, a British manufacturer wishes to borrow US Dollar at a fixed rate of

interest. Company ABC a US, MNC wishes to borrow sterling pounds at a fixed rate of
interest. The rates are as follows:

Company Sterling USD

XYZ 11% 7.5%
ABC 10.6% 6.2%
Design a swap that will have a bank acting as intermediary 40 basis points per annum and
which will produce a gain of 25 BPS pa for each of the two companies.

Solution:
The maximum spread is existing in USD market (7.5 – 6.2) 1.3% compared that of Sterling
market i.e (11 – 10.6%) = 0.4%. Therefore Company ABC will borrow from USD market
and give to Company XYZ. On the other hand Company XYZ will borrow from Sterling
market and give to Company ABC.
Difference in Sterling market is 11 – 10.6 = 0.4%
Difference in USD market 7.5 – 6.2 = 1.3%
Comparative advantage 1.3 – 0.4 = 0.9%
Intermediary charges 0.40%
Net benefit = 0.9% - 0.4% = 0.5%
Net benefit to each company 0.5 /2 = 0.25% each
Net cost to Company XYZ = 7.5 – 0.25= 7.25
Net cost to Company RAK = 10.6 – 0.25= 10.35%
Pays 6.6 % in USD Receives 6.2% in USD
XYZ INTER ABC
Receives 10.35% in Pays 10.35% in
Sterling Sterling
Pays 11% in
Pays 6.2%
Sterling
in USD

Lender in Lender in
Sterling Market USD Market
Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College
 Interest Rate and Currency SWAPS

Cash Flow to Company XYZ Cash Flow to Company ABC

Receives on Sterling 10.35% Receives USD 6.2%
Pays on Sterling 11.00% Pays USD 6.2%
Pays on USD 6.60% Pays Sterling 10.35%
Net Rate 7.25% Net Rate 10.35%
7. Three companies X, Y and Z have come together to reduce their interest cost. Following
are the requirement of those companies and interest rates offered to them in different
markets.

Company Requirement Fixed $ Floating $ Fixed Euro

X Fixed $ 5.75% LIBOR + 0.9% 6.00%
Y Floating $ 5.25% LIBOR + 0.75% 6.50%
Z Fixed Euro 6.00% LIBOR + 0.6% 6.25%
The amount required by the companies are equal and are for three years on bullet payment
basis. You are required to arrange swap between three parties in such a way so that the
benefit of swap is equally divided among the three companies.

Solution:
 The lower interest rate in Fixed $ market is 5.25% at which company Y can borrow
and lend to company X which is interested in borrowing from fixed $ market.
 The lower interest rate in Floating $ market is LIBOR + 0.6% at which company Z
can borrow and lend to Company Y which is interested to borrowing from floating $
market.
 The lower interest rate in fixed euro market is 6.00% at which company X can borrow
and lend to Company Z which is interested in borrowing from fixed Euro market.
Cost of funds without swap
X company applicable rate in Fixed $ market is 5.75%
Y company applicable rate is Floating $ market is L+0.75%
Z company applicable rate in Fixed Euro market is 6.25%
Total 12.75%

Cost of funds with Swap

X company applicable rate in Fixed Euro market is 6.00%
Y company applicable rate is Fixed $ market is 5.25%
Z company applicable rate in Floating $ market is L + 0.60%
Total 11.85%

Net benefit from swap 12.75 – 11.85 = 0.9%

Benefit to each company 0.9 / 3 = 0.3% each
Net rate for Company X = 5.75 – 0.3 = 5.45%
Net rate for Company Y = LIBOR + 0.75 – 0.3 = L + 0.45%
Net rate for Company Z = 6.25 – 0.3 = 5.95%

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College

 Interest Rate and Currency SWAPS

Pays 6.0% to lender

in Fixed Euro
Market

Y Z
Y Pays to Z L +
0.65%
Pays 5.25% to lender in Pays L + -.6% to lender
Fixed Dollar Market in Floating USD Market

Cash Flow to Company X

Receives from Z 6.00
Pays on Fixed Euro Market 6.00
Pays to Y 5.45
Net Rate 5.45

Cash Flow to Company Y

Receives from X 5.45
Pays to lender in Fixed Dollar Market 5.25
Pays to Z L + 0.65
Net Rate L + 0.45
Cash Flow to Company Z
Pays to X 6.00
Pays to lender in Floating Dollar Market L + 0.60
Receives from Y L + 0.65
Net Rate 5.95

8. A Commercial bank wants $ floating rate loan. A manufacturing company wants fixed
rate $ funds. An US financial institution wants $ floating prime rate loans. The cost of
accessing funds in each market is as below:
Fixed Floating LIBOR Floating Prime
CB 12% LIBOR + 0.2% Prime + 0.3%
MC 11% LIBOR + 0.2% Prime + 0.4%
FI 10% LIBOR Prime + 0.8%
Explain how a swap can be structured if the total benefit is to be shared equally.

Solution:
Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College
 Interest Rate and Currency SWAPS
 The lower interest rate in Fixed rate market is 10% at which FI can borrow and lend
to MC which is interested in borrowing from fixed rate market.
 The lower interest rate in Floating LIBOR is LIBOR + 0.2% at which MC can borrow
and lend to CB which is interested to borrowing from floating LIBOR market.
 The lower interest rate in Floating Prime market is Prime + 0.3% at which CB can
borrow and lend to FI which is interested in borrowing from Floating Prime market.
Cost of funds without swap
CB applicable rate in $ Floating LIBOR Markett is L + 0.2%
MC applicable rate is Fixed is 11.0%
FI applicable Floating Prime rate is P + 0.8%
Total 12.0%

Cost of funds with Swap

FI applicable rate in Fixed market is 10.00%
MC applicable rate in Floating LIBOR market is L + 0.20%
CB applicable rate in Floating Prime market is P + 0.30%
Total 10.50%

Net benefit from swap 12.00 – 10.50 = 1.5%

Benefit to each company 1.5 / 3 = 0.5% each
Net rate for CB = L+ 0.2% - 0.5% = L - 0.3%
Net rate for MC = 11 – 0.5 = 10.5%
Net rate for FI = P + 0.8 – 0.5% = P + 0.3%

Pays P + 0.3% to lender in

Floating Prime Market

CB

MC FI
MC Pays 10% to FI

Pays L + 0.2% to lender in Pays 10% to lender in

Floating LIBOR Market Fixed Market

Cash Flow to Company CB

Receives from FI P + 0.3%
Pays on Floating Prime Market P + 0.3%
Pays to MC L – 0.3%
Net Rate L – 0.3%

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College

 Interest Rate and Currency SWAPS
Cash Flow to Company MC
Receives from CB L - 0.3%
Pays on Floating LIBOR Market L + 0.2%
Pays to FI 10.00%
Net Rate 10.50%

Cash Flow to Company FI

Receives from MC 10.00%
Pays on Fixed Market 10.00%
Pays to CB P + 0.3%
Net Rate P + 0.3%

9. A Swap was entered by an Indian firm with a bank converting its rupee liability into British
pound, where the firm received 10% on Indian rupee and paid 6% on British pound. The
amount of principals involved are ₹ 120 million and £1.5 million fixed at the exchange
rate of ₹ 80 per £. The swap has 4 semi-annual payments to follow.

Assume the next payment is due after 6 months from now and term structure in Indian
rupee and British pound is flat at 9.00% and 5.50% respectively, for the next 2 years. If
the current exchange rate is ₹ 82.00 per £, what is the value of the swap for the Indian firm
and the bank?

Solution:
The semi-annual payment of interest is 0.05 * 120 = ₹ 6 million. The final payment would
be ₹ 126 million, including the principal amount. With a 9% flat term structure on
continuous compounding the PV of the receivable by the firm from the bank would be:

PV of rupee cash flow = 6e-0.09 * 0.5 + 6e-0.09 * 1 + 6e-0.09*1.5 + 126e-0.09*2

= 5.7360 + 5.4836 + 5.2423 + 105.2440
= Rs.121.7059 million

PV of rupee cash flow in pound terms = 121.7059 / 82 = £ 1.4842 million

PV of pound cash flow = 0.045e-0.055 * 0.5 + 0.045e-0.055 * 1 + 0.045e-0.055*1.5 + 1.545e-0.055*2

= 0.0438 + 0.0426 + 0.0414 + 1.3841
= £ 1.5119 million
PV of pound cash flow in rupee terms = 1.5119 * 82 = Rs.123.9735
Value of the swap for Firm Bank
(in millions) ₹ £ ₹ £
Rupee leg -121.71 1.4842 121.71 1.4842
Pound leg 123.97 1.5119 -123.97 -1.5119

10. A firm had entered into a swap arrangement for a notional principal of ₹ 1 crore with a
bank, whereby the bank paid a fixed 9% and received MIBOR semi-annually. It has three
more years to go, and had just exchanged the cash flow. The 6-m MIBOR for the next
payment of interest was reset at 8%. The next day, the markets exhibited a fall and the 6-
m MIBOR fell to 7%. Leading the firm to believe that it is overpaying, it wants to cancel
the swap arrangement. How much should the firm ask the bank to pay to cancel the swap
deal? Assume a flat term structure.

Solution:
The Value of the swap for the firm is determined on the basis of discounted cash flows
(DCFs). Since the rates have changed, the discount rate used would be 7% of the prevalent
Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College
 Interest Rate and Currency SWAPS
market rate. The value of the cash outflows on a fixed basis discounted at 7% is Rs.104.99
as shown here:

Present value of cash flow of the fixed leg

Fixed leg payment - cash outflow 9.00%
Present 12-month MIBOR 7.00%
Next interest payment on floating rate 8.00%
DCF
Years
Time (Months) Cash Flow (₹) (₹ At 7.00%)
- 4.5
6 0.50 4.5 4.35
12 1.00 4.5 4.20
18 1.50 4.5 4.05
24 2.00 4.5 3.91
30 2.50 4.5 3.78
36 3.00 104.5 84.71
Present value of Fixed leg 105.00
The
PV of the inflow at a floating rate would be the next interest payment, decided a period in
advance, plus the face value of ₹ 100 discounted at 7%. This amount works out to ₹ 100.42

Value of Floating leg

Interest to be received after 6 months : 4.00
Principal to be received after 6 months :100.00
Total :104.00
Present value at 7% :100.42

The present value of the cash outflow is more by ₹ 4.58 for a principal of ₹ 100. If the
bank pays ₹ 4.58 lakh for the principal amount of ₹ 1 crore, the firm may exit the swap.

Prof. Sathyanarayana K, Associate Professor, Department of MBA, Surana College