● The tables and figures in this PPT document

are from the supporting teaching PPT

documents of the textbook.

● The textbook of this course

■ Cheol S.Eun, Brunce G. Resnick, International

Financial Management (8th Edition)

Chapter 8

Interest Rate Swaps

& Currency Swaps

Lecturer

Shanghai University of International

Business and Economics

Wu Tingting

Interest Rate Swaps

8

& Currency Swaps

Chapter Eight

INTERNATIONAL

Chapter Objective: FINANCIAL

MANAGEMENT

This chapter discusses interest rate swaps and

currency swaps, which are relatively new

Fourthrate
instruments for hedging long-term interest Edition

risk and foreign exchange risk. EUN / RESNICK

Chapter Outline

●●
● Types
Types of Swaps
of Swaps Rate Swaps
8.1 Interest

Size of
●● Size of the
the Swap
Swap Market
Market

● 8.2 Currency Swaps

The Swap
●● The Swap Bank
Bank

Swap Market
●● Swap Market Quotations
Quotations
◆ To hedge long-term foreign

Interest Rate
●● Interest Rate Swaps
Swaps

exchange
Currency
●● Currency Swapsrisk: currency swaps
Swaps

To hedge
Variations
Variations
●● ◆ of long-term
of Basic
Basic Interest interest
Interest Rate
Rate rateSwaps
and Currency
and Currency Swaps

risk:
Risks
●● Risks of interest
of Interest
Interest Raterate
Rate and swaps Swaps
and Currency
Currency Swaps

Is the
●● Is the Swap
Swap Market
Market Efficient?
Efficient?

Content of “8.1 Interest Rate Swaps”

●1.
● Types
Definition
Types of Swaps
of Swaps
& Types of Interest Rate Swaps

2.
●● Size
Swap
Size of the
of the
Banks
Swap
Swap &Market
Market
Interest Rate Swap Quotations

3.
●● The
A Mini-case
The Swap Bank
Swap Bankof Interest Rate Swaps

●● Swap Market
Swap Market Quotations
Quotations

●● Interest Rate
Interest Rate Swaps
Swaps

●● Currency Swaps
Currency Swaps

●● Variations of
Variations of Basic
Basic Interest
Interest Rate
Rate and
and Currency
Currency Swaps
Swaps

●● Risks of
Risks of Interest
Interest Rate
Rate and
and Currency
Currency Swaps
Swaps

●● Is the
Is the Swap
Swap Market
Market Efficient?
Efficient?

Why do we need to learn about interest rate

swaps？

A Mini-case

Capital can freely move between country A and country

B.

➢ The N-year interest rate of currency B is much higher

than that of currency A.

➢ A cross-border arbitrage chance: borrow in country A

and invest in country B.

Case Analysis

At the end of each year (from 1st~ (N-1)th year)

➢ Get investment returns in terms of currency B and pay loan interests

in terms of currency A.

● At the end of the Nth year

➢ Get investment returns and principal in terms of currency B and

pay back loan interests and principal in terms of currency A.

Definition and Types

➢Definition of Interest Rate Swaps

■ In an interest rate swap, two counterparties agree to a

contractual arrangement to exchange cash flows at

periodic intervals.

Types of Interest Rate Swaps

■ Single currency interest rate swap Interest rate swap

■ Cross-Currency interest rate swap Currency swap

Interest Rate Swaps

In a broad sense: single-currency & cross-

currency ones

In a narrow sense: only single-currency ones

●

狭义利率互换：货币单⼀

Interest Rate Swaps in a Narrow Sense

Basic Interest Rate Swaps

最基础的

■ “Plain vanilla” fixed-for-floating interest rate swap

● Variations of Basic Interest Rate Swaps

■ Zero-coupon for floating 零息债券（折价发⾏）

■ Floating for floating

■ Amortizing 摊销/分期付款（本⾦逐渐减少）

■ ……

10


The Swap Currencies

国际货币

●The most popular currencies are:

■ U.S. dollar

■ Japanese yen

■ Euro

■ Swiss franc

■ British pound

11


Swap Bank

● What is a swap bank?

■ A swap bank is a generic term to describe a financial

institution that facilitates swaps between counterparties.

● Who can be a swap bank?

■ An international commercial bank, an investment bank, or

an independent operator.
独⽴运营者

● What role does a swap bank play?

■ A broker 中间商作为dealer，有⻛险与pricegap，

■ A dealer 作为broker ⽆⻛险⽆差价

12


Different Roles of a Swap Bank

Table 1

The Role of Swap Do they bear What do they get?

Banks swap risks?

Brokers No Commissions

Dealers Yes Profits coming from

a price gap

13


Table 2 Interest Rate Swap Quotations

Euro-€ £ 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 ask price卖出

5.18 1.23 1.31 3.90 3.94

3-year 2.86 2.893.82–3.85

bid5.13
means 1.50
price买⼊ 5.17
the swap
1.58bank4.11
will pay
4.13

4-year 3.06
fixed-rate5.17
3.09 5.12
euro payments
1.73
at 3.82%
1.81 4.25 4.28

5-year 3.23
against receiving
3.26 5.11 5.16
euro LIBOR
1.93 2.01
or it will
4.37 4.39

receive fixed-rate euro payments at

6-year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50

3.85% against paying euro LIBOR.

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

14


• Question: What can we do with interest

相对⽐较理论（⼤卫李嘉图）

rate swaps? 利率互换前提条件：

各⾃具有⽐较优势且被对⽅需要

Main Functions of Interest Rate Swaps

➢To hedge against long-term interest rate

risk

➢To save financing cost

15
 A Mini-case of Interest Rate Swaps
● Bank A is an AAA-rated international bank and wants to
raise $10 millions to finance floating-rate Eurodollar
loans.
■ It is considering to issue 5-year fixed-rate Eurodollar bonds at 10%
or issue floating-rate notes at LIBOR.
● Firm B is a BBB-rated company and needs to raise $10
millions to finance a capital investment with a five-year
economic life.
■ It is considering to issue 5-year fixed-rate Eurodollar bonds at
11.75% or issue 5-year floating-rate notes at LIBOR+0.5%.

16
 Table 1 Borrowing Opportunities of A and B
Firm B Bank A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR

17
 Quality Spread Differential
◆ General meaning: the potential gains from a
swap transaction shared among all the swap
participants
◆ Specific definition: the difference between the
default-risk premium differential on the fixed-rate
debt and the default-risk premium differential on
the floating-rate debt.

18
 QSD Calculating Methods
● Method 1: according to its meaning
■ Total financing cost without swap － Total financing
cost with swap
● Method 2: according to its definition
■ Default-risk premium differential on the fixed-rate
debt － Default-risk premium differential on the
floating-rate debt

19
 Table 1 Borrowing Opportunities of A and B
Firm B Bank A

Fixed rate 11.75% 10%

Floating rate LIBOR + 0.5% LIBOR
➢ Method 1: according to its meaning
Total financing cost without swap - the total
financing cost with swap = (LIBOR + 11.75%) –
(LIBOR+0.5% +10%) = 1.25%

20
 Table 1 Borrowing Opportunities of A and B
Firm B Bank A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR
➢ Method 2: according to its definition
Default-risk premium differential on the fixed-rate
debt － Default-risk premium differential on the
floating-rate debt
= (11.75% -10%) – [(LIBOR+0.5%) –LIBOR] =
1.75% - 0.5% = 1.25%
21
 How to share the QSD?
●There is no reason to presume that the swap benefits will
be shared equally.
●Lower credit rating Firm B: less of the QSD.
●Higher credit rating Bank A: more of the QSD.

22
● Why does the QSD exist?
● Why the two counterparties can reduce the
financing cost through an interest-rate swap?
Two Famous International Trade Theories
● Absolute Advantage Theory (Adam Smith)

● Comparative Advantage Theory (David

Ricardo)

23
 Table 1 Borrowing Opportunities of A and B
Firm B Bank A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR

24
Three Steps to Realize Swap Benefits

● Step1: Find which counterparty has a

comparative advantage in raising fixed-rate debt /
floating-rate debt.
● Step2: Calculate the QSD.
● Step3: Negotiate how to share the QSD among
the swap participants and sign one or two swap
contracts.
■ Case1: if swap bank acts as a broker
■ Case2: if swap bank acts as a dealer

25
 A Mini-case of Interest Rate Swaps

The swap bank makes

Swap this offer to Bank A:
Bank You pay LIBOR –
10.375% 0.125% per year on $10
LIBOR – 0.125%
million for 5 years and
we will pay you 10.375%
Bank A on $10 million for 5
years.

FIRM B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR

26
 A Mini-case of Interest Rate Swaps
Cost savings per year
0.5%×$10 million =
①Interests Saved on the
$50,000
Cost savings for 5 years Swap floating-rate debt:
= $250,000 LIBOR- (LIBOR - 0.125%)
Bank =0.125%
10.375% ②Profits earned on the
fixed-rate debt:
LIBOR – 0.125%%
10.375% - 10% = 0.375%
10% Bank A ①+②=0.5%

FIRM B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR

27
 A Mini-case of Interest Rate Swaps

The swap bank makes Swap

this offer to Firm B:
You pay us 10.5% per Bank
10.5%
year on $10 million for 5
years and we will pay LIBOR – 0.25%
you LIBOR - 0.25% per Firm B
year on $10 million for 5
years.
FIRM B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR

28
 A Mini-case of Interest Rate Swaps
Cost savings per year
0.5% ×$10 million =
①Interest Losses on the $50,000
Swap Cost savings for 5 years
floating-rate debt:
Bank = $250,000
LIBOR + 0.5% -
(LIBOR-0.25%) = 0.75% 10.5%
②Interest savings on the LIBOR – 0.25% LIBOR
fixed-rate debt: + 0.5%
11.75% - 10.5% = 1.25% Firm B
Net saved interest payment
= ② - ① = 0.5%

FIRM B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + 0.5% LIBOR

29
 A Mini-case of Interest Rate Swaps
0.25%+0.5%+0.5%
= 1.25% = QSD
The swap bank makes 0.25%
Swap 0.25%×$10 million =
$25,000 per year for 5
Bank years.
10.375% 10.5%

LIBOR – 0.125% LIBOR – 0.25%

Bank Firm
A B
A saved 0.5% B saved 0.5%

30
Content of “8.2 Currency Swaps”
◆ (1)Preliminaries of Currency Swaps
➢ Definition
➢ Types
➢ Reasons
➢ Double Problems
◆ (2)A Mini-case of Currency Swaps

31
 Definition of Currency Swaps
➢In a currency swap, one counterparty
exchanges the debt service obligations
denominated in one currency for the debt
service obligations of the other counterparty
denominated in another currency.

32
 Types of Currency Swaps

■fixed for fixed (the basic type)

■fixed for floating
■floating for floating
■amortizing

33
 What can we do with a currency
swap?
■To save financing cost
■To hedge long-term foreign exchange
rate risk

34
 An Example of a Currency Swap

●Financing need of a U.S. MNC: to finance a £10

million expansion of a British plant
●Two financing choices:
① To borrow dollars in the U.S. and convert dollars
into pounds Problem: foreign exchange risk
② To borrow pounds in the U.K. directly Problem:
to pay a default-risk premium

35
 The Double Problems
Faced by a MNC
• Double Problems
• Be confronted with long-term transaction
exposure
• Borrow at a disadvantageous rate

● This dilemma is for any MNC who wants to

raise foreign currency for its foreign subsidiary.
● How to deal with the dilemma?

36
What is a mirror-image financing need?
● Firm A needs currency B and Firm B needs
currency A.
● The value of the two financing needs is the same
in terms of either currency A or currency B,
with consideration of the current spot rate.
● The maturities of the two financing needs
should also be the same.

37
 A Mini-case of Currency Swaps

Table 1
$ £
Firm A 8.0% 11.6%
Firm B 10.0% 12.0%
A has a comparative advantage in raising dollars.
B has a comparative advantage in raising pounds.

38
 What should A and B do?
■A borrowed dollars, B borrowed pounds[Current
spot exchange rate: S0($/£)= $1.6/£ 16 million debt
= £10 million]
■ To sign a currency swap contract

■ To share the QSD

39
● However, in the real life, it’s difficult for a
MNC to find another MNC with the mirror-
image financing need. So they usually resort
to a financial institution.
● A swap bank familiar with the financing
needs of the two MNCs could arrange a
currency swap that would solve the double
problems of each MNC which we talked
about just now.
40
 A Mini-case of Currency Swaps
Firm A saved
£0.6%: Swap
(11.6%-11%) ×
£10 million Bank
= £60,000 per year $8%

£11%
$8% Firm < £11.6%
A

$ £
Firm A 8.0% 11.6%
Firm B 10.0% 12.0%
41
A Mini-case of Currency Swaps
Firm B saved
£0.6%:
(10%-9.4%) × $16
Swap million
= $96,000 per year
Bank
$9.4%
< 10%
£12%
Firm £12%
B

$ £
Firm A 8.0% 11.6%
Firm B 10.0% 12.0%
42
 A Mini-case of Currency Swaps

Swap
Bank
$8% $9.4%

£11% £12%
Firm Firm
A B
Swap bank lost 1% Swap bank gained
on £: (11%-12%) × 1.4% on $:
£10 million (9.4%-8%) × $16
= - £100,000 per year million
= $ 224,000 per year
43
 A Mini-case of Currency Swaps

1.4% of $16 million

The swap bank makes Swap financed with 1% of
money too.
Bank £10 million per year
$8% $9.4% for 5 years.
£11% £12%
Firm At S0($/£) = $1.60/£, that Firm
A is a net profit of $64,000 B
A: 0.6% per year for 5 years.
B: 0.6%
Swap Bank: 0.4% $224,000
0.6%+0.6%+0.4% –$160,000
= 1.6%
= QSD $64,000
44
 The Process of a Currency Swap
① At inception, the principal sums would be exchanged
through the swap bank .(the current exchange rate)
② Over the term of the currency swap, the fixed interest
payment in different currencies would be exchanged
between the two counterparties through the swap bank
each year. (two contractual exchange rates)
③ At the maturity date of the currency swap, the principal
sums would be reexchanged and the final interest
payment would also be exchanged through the swap
bank. (two contractual exchange rates)
45

45
 How to solve a problem of a
currency swap : A Step Summary
● The Solving Process:
● Step 1: Analyze each counterparty’s comparative
advantage and arrange a currency swap with/without a
swap bank.
● Step 2: Calculate the QSD (pay special attention to this).
● Step 3: Calculate how much interest payment should be
given to the counterparty each year over the term of the
currency swap and calculate the contractual exchange
rate according to the interest payments denominated in
different currencies.

46
 What are the functions of a currency
swap?
● Function (1): It can solve the double problems of
each MNC.
● Function (2): Each MNC can not only solve its
double problems, but also benefit from a currency
swap.
● Function (3): It serves to contractually lock in a
series of future exchange rates for the debt service
obligations of each counterparty over the term of
the swap, which can help each MNC avoid foreign
exchange risk.
47
 Swap Risks
● Credit Risk
● Exchange rate Risk
● Sovereign Risk
● Mismatch Risk
● Interest Rate Risk
● Basis Risk

48
 Risks of Interest Rate
and Currency Swaps
● 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.
● Exchange rate Risk
■ In the example of a currency swap given earlier, the
swap bank would be worse off if the pound appreciated
or the dollar depreciated.
● Sovereign Risk
■ The risk that a country will impose exchange
restrictions (exchange control) that will interfere with
performance on the swap.
49
 Risks of Interest Rate
and Currency Swaps (continued)
● Mismatch Risk
■ It’s hard to find a counterparty that wants to borrow the right
amount of money for the right amount of time.
● 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.

50
 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.
● For a swap to be possible, a QSD must exist.
Beyond that, creativity is the only limit.

51