HBIB0012-3001 Global Financial Management

(online)
Topic 5: Swaps

Swaps: Dr. Shab Hundal 1

Topic Objectives:
1. To explain how swap contracts (interest rate
and currency) are used by the MNCs for
hedging, based on anticipated exchange and
interest rate movements.
2. To understand working mechanism of swaps
and effects of the exchange and interest rate
movements on investors, in the real life scenario.
3. To understand the role of financial
intermediaries in the context of swaps.

Swaps: Dr. Shab Hundal 2

Swaps:
•An exchange of future cash flow obligations between two
parties.
• Swaps are the OTC financial instruments which are used to
hedge against interest rate risks, foreign currency exposure
etc.
• Outstanding value of the currency swaps and interest rate
swaps was $19,271billion and 364,378 billion respectively in
Dec. 2010 (BIS Quarterly Review, June 2011).
• Swap market emerged in the late 1970s as currency
traders used swaps to evade British control on the
movement of foreign currency.

Swaps: Dr. Shab Hundal 3

Most Popular Types of Swaps:
1)Interest rate swaps
2) Currency swaps

Swaps: Dr. Shab Hundal 4

1) Interest Rate Swaps:
Exchange of interest payments (not principal amounts) for
two different types of loans in the same currency
-fixed interest rate vs. floating interest rate.

“An agreement between two parties (known as

counterparties) where one stream of future interest payments
is exchanged for another, based on a specified notional
(reference) amount, a theoretical principal amount against
which all interest payments/receipts are calculated for a
specified period of time”.

Note: Exchange of interest payments only, underlying

notional principal is never exchanged. Generally used to
hedge long term borrowings.
Swaps: Dr. Shab Hundal 5
Swaps are OTC Traded: contracts set up between two or
more parties, and can be customized (why??).
•Firms and financial institutions are the main players in the
swap market.
• Financial institutions act as intermediaries.
• Some risk of a counterparty defaulting is always present.
• Interest payments may be made annually, quarterly,
monthly, or at any other interval determined by the parties.
• Negotiated terms include starting and ending dates,
settlement frequency, notional amount on which swap
payments are based, and published reference rates on
which swap payments are determined.
• The maturity period can be between one to fifteen years.

Swaps: Dr. Shab Hundal 6

Coupon Swap/ Plain Vanilla Interest Rate Swap:
“Plain vanilla” swaps are the most common type of
interest rate swaps. Payments made by one
counterparty are based on a floating rate of interest,
such as the London Inter Bank Offered Rate
(LIBOR), while payments made by the other
counterparty are based on a fixed rate of interest.

See LIBOR document in OPTIMA

Swaps: Dr. Shab Hundal 7

Example 1: Assume that counterparties A and B require $100 million each
for a five year period. A is a BBB rated company and wants to borrow at a
fixed rate. B is AAA company and it wants to borrow at floating rate.

How would they use interest rate swap contract to hedge their cash flow
risks and at the same time reducing cost of borrowing?

Borrower Fixed Rate Floating Rate

Counterparty 8.5% 6-month LIBOR
A: BBB-rated + 0.5%
Counterparty 7.0% 6-month LIBOR
B: AAA-rated
Quality Spread 1.5% 0.5%

Does Principle of comparative cost advantage come in picture?

Swaps: Dr. Shab Hundal 8

Solution:
In the fixed rate interest market the difference between the
credit quality of AAA-rated company and BBB-rated company
is 1.5% (150 basis points), whereas, the same is 0.5% (50
basis points) in the floating rate interest market. Hence there
is an anomaly of 1% (100 basis points) that can be shared by
the counterparties and the financial intermediary.
•Above cited differences 1.5% and 0.5% are also called
quality spreads.
• Difference of Differences:1.5% and 0.5%= 1% (100 basis
points) is called effective swap spread which is the basis of
gain to the counterparties and bank.
• Spread is the risk premium, and it is based on the credit
rating of the customer. The spread is higher when the credit
rating is lower.
Swaps: Dr. Shab Hundal 9
Hypothetical Solution:
One possible transaction would be that Firm B borrows a loan from the
market at 7% and sells it to Firm A at 8%.
By doing so, Firm A reduces costs by 0.5% (8.5% – 8.0%), and
Firm B earns 1.0% (8 – 7).
Total benefit = 0.5% + 1.0% = 1.5% = Difference in fixed-rate
However, in this transaction Firm B would bear the risk that Firm A may fail to
meet its payment obligations.
Realistic Action by A:
Phase 1: A should borrow $100 million five year floating rate Eurodollar loan
from a syndicate of banks at an interest rate 6-month LIBOR + 0.50% (50
basis points).
Phase 2: A enters into swap contract through financial intermediary
(generally a global bank), that it would pay 7.35% (?) rate of interest to the
financial intermediary on the notional amount of $100 million and
Phase 3: Financial intermediary would pay to A, a 6 month LIBOR (LIBOR6).

Swaps: Dr. Shab Hundal 10

Net cost to A is
7.35%+ LIBOR + 0.50%-LIBOR= 7.85%,
Therefore, A has swapped floating-rate loan for a fixed-rate loan paying
7.85%.
This is lesser than 8.5% that it would have paid in the absence of swap
contract. Therefore, out of 1% anomaly, A has taken advantage of 0.65%
(65 basis points).

Realistic Action by B:
Phase 1: B issues $100 million, five year Eurobond carrying 7% fixed rate.
Phase 2: B agrees to pay LIBOR to the financial intermediary,
Phase 3: who in turn would pay 7.25% to B.
Hence, B has swapped a fixed-rate loan for a floating-rate loan by
effectively paying LIBOR minus 0.25% (25 basis points).
Net cost to B is
7%+LIBOR-7.25%= LIBOR-0.25% (25 basis points).

Swaps: Dr. Shab Hundal 11

 How much would bank gain?

Counterparty Bank Bank Pays Bank’s Gain

Receives

A 7.35% LIBOR6 7.35% minus

LIBOR6

B LIBOR6 7.25% LIBOR6

minus 7.25%

Net Gain 0.10% (10

basis points)

Swaps: Dr. Shab Hundal 12

Observations: 1. Sources of funding are not swapped.
2. Interest rate obligations are swapped (e.g., from a floating
or variable interest rate basis to a fixed interest rate basis, or
vice versa). Party A agrees to pay Party B a predetermined,
fixed rate of interest on a notional principal on specific dates
for a specified period of time. Concurrently, Party B agrees to
make payments based on a floating interest rate to Party A
on that same notional principal on the same specified dates
for the same specified time period.
3. Financial institutions can be a counterparty as well as an
intermediary.
4. Any potential gain is shared between counterparties and
intermediary.

Swaps: Dr. Shab Hundal 13

Exercise 1. Companies X and Y are interested in raising funds. Y can
raise funds in fixed and floating markets at 10% and LIBOR+0.25%
respectively. X can raise funds in fixed and floating markets at 10.75% and
LIBOR+0.75% respectively. These rates are applicable for a borrowing of
$100 million for two years. Both X and Y can borrow in both fixed as well
as floating markets, but X is interested in borrowing at fixed interest rate
while Y is interested in borrowing at floating rate. Explain how a swap
agreement would help them gain equally, assuming:
a. There is no gain shared by the financial intermediary.
b. Financial intermediary charging 0.1% (10 basis points) from each
of the counterparties.
Borrower Fixed Rate Floating Rate
Counterparty X 10.75% LIBOR + 0.75%

Counterparty Y 10% LIBOR+ 0.25%

Quality Spread 0.75% 0.50%

Swaps: Dr. Shab Hundal 14
Solution:

•Notice absolute and comparative cost advantage. There is

an anomaly of 0.25% (25 basis points) that can be shared by
the counterparties and the financial intermediary.
• Above cited differences 0.75% and 0.50% are also
called quality spreads.
• Difference of Differences:0.75% and 0.50%= 0.25% (25
basis points) is called effective swap spread which is the
basis of gain to the counterparties and bank.
• In part (a) entire effective swap spread would equally be
shared by counterparties only.

Swaps: Dr. Shab Hundal 15

(a): Net cost to X is
10.125%+ (LIBOR + 0.75%) - (LIBOR + 0.25%)= 10.625%,
Therefore, X has swapped floating-rate loan for a fixed-rate
loan paying 10.625%. This is lesser than 10.750% that it
would have paid in the absence of swap contract. Therefore,
out of 0.25% anomaly, X has taken advantage of 0.125% (12.5
basis points).

•Net cost to Y is
10%+ (LIBOR+ 0.25%) - 10.125%= LIBOR + 0.125% (12.5
basis points gain).

Swaps: Dr. Shab Hundal 16

 Bank’s Gain/Loss
Counterparty Bank Receives Bank Pays Bank’s Gain

X 10.125% LIBOR+0.25% 10.125%

minus(LIBOR+0.25%)

Y (LIBOR+0.25%) 10.125% (LIBOR+0.25%) minus

10.125%

Net Gain 0% (0 basis points)

Swaps: Dr. Shab Hundal 17

In (b) net gain of bank should be 20 basis points bank
should take away 10 basis points from each
counterparty.
Net cost to X is
10.225%+ (LIBOR + 0.75%) - (LIBOR + 0.25%)= 10.725%,
Therefore, X has swapped floating-rate loan for a fixed-rate
loan paying 10.725%. This is lesser than 10.750% that it
would have paid in the absence of swap contract. Therefore,
out of 0.025% anomaly, X has taken advantage of 0.025%
(2.5 basis points).

Net cost to Y is
10%+ (LIBOR+ 0.25%) - 10.025%= LIBOR + 0.225% (2.5
basis points gain).
Swaps: Dr. Shab Hundal 18
 Bank’s Gain/Loss
Counterparty Bank Receives Bank Pays Bank’s Gain

X 10.225% LIBOR+0.25% 10.225% minus

(LIBOR+0.25%)

Y (LIBOR+0.25%) 10.025% (LIBOR+0.25%)

minus 10.025%

Net Gain 0.200%

(20 basis
points)

Swaps: Dr. Shab Hundal 19

2) Currency Swaps: “A currency swap is an arrangement to
exchange principal plus fixed interest in one currency for the
principal plus fixed interest in another currency.”

Therefore, currency swap is an exchange of debt-service

obligations (cash flows) denominated in one currency for the
service of an agreed-upon principal amount of debt
denominated in another currency.

A currency swap is a way to hedge exchange rate risk.

Companies can borrow in their home currencies in order to
take comparative advantage.

Swaps: Dr. Shab Hundal 20

Remember: Two counterparties exchange
principal + interest obligations in one currency
with principal + interest obligations in other
currency.

•This characteristic differentiates currency swaps

from interest rate swap (e.g. plain vanilla swap).

• For the interest rate swap notional amount is not

swappable.

Swaps: Dr. Shab Hundal 21

Phase 1: Notional (principal) amount is swapped at the start
of the contract.
Phase 2: During the life time of the contract (say after every
6 months) interest payments are also swapped.
Phase 3: Finally, at the expiry of the contract, principals are
swapped again.

A currency swap contract can be viewed as a series of

forward contracts. The counterparties agree to pay a definite
sum (principals as well as interest payments) in future.

A currency swap is not a loan, therefore, does not change the

liability structure of the counterparties.

Swaps: Dr. Shab Hundal 22

Example 2 Fixed-For-Fixed Currency Swap:
X is a US based company and it wants to hedge its euro exposure worth
$200 million. Y is a French company and it wants to hedge its USD
exposure equivalent of $200 million (€220 million at the current spot rate
$1= €1.1). Both companies want to borrow at fixed rate for the period of
10 years.
The following matrix shows the cost of dollar and euro denominated debts
that both companies can raise.
Company Interest Rate on Interest Rate on
dollar denominated euro denominated
debt debt
US Company (X) 7.5% 8.25%
French Company 7.7% 8.1%
(Y)

From above table it is clear that both the US and French companies, on
the basis of comparative cost advantage, should borrow in their domestic
currencies (Why??).
Swaps: Dr. Shab Hundal 23
Initial Phase:
US company borrows $200 million from a US based bank, and swap with
the French company for €220 million through a financial intermediary
(usually a global bank). The amount €220 million is actually borrowed by
the French firm from say some France based bank.

Exchange of Interest Payment Phase:

1. Annual interest cost on the dollar denominated debt is
$200 million × 7.5% = $15,000,000
This annual interest cost would be paid by the French company to the US
company, which would in turn pay to the US bank. This cash flow would
be for the period 1 to 10 years.
2. Annual interest cost on the euro denominated debt is
€220 million × 8.1% = €17,820,000
This annual interest cost would be paid by the US company to the French
company, which would in turn pay to the French bank. This cash flow
would be for the period 1 to 10 years.

Swaps: Dr. Shab Hundal 24

Final phase (exchange of payments):
At the end of tenth year (expiration period), French company would
return $200 million to the US company, which in turn would repay to the
US bank.
Similarly, the US company would return €220 million to the French
company, which in turn would repay to the French bank.
Gain to the counterparties:
US company borrows Euros at 8.1%. In the absence of swap it would
have paid 8.25%.
US company gains 8.25% minus 8.1%= 0.15% (15 basis points)
French company borrows USD at 7.5%. In the absence of swap it would
have paid 7.7%.
French company gains 7.7% minus 7.5%= 0.2% (20 basis points)

Swaps: Dr. Shab Hundal 25