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Currency and interest rate

swaps

To understand swaps as a hedging technique


To create currency and interest rate swap
To evaluate the present scenario
They said
• [D]erivatives are financial
weapons of mass destruction,
carrying dangers that, while
now latent, are potentially
lethal."
—Warren Buffett, Berkshire Hathaway
2002 Annual Report
• "When used properly,
derivatives are a valuable risk
management tool…"
—Kathryn E. Dick, OCC Deputy
Comptroller for Risk Evaluation
Derivatives:
The ugly, the bad and the
good
Broad Areas
üTypes of Swaps
üSize of the Swap Market
üThe Swap Bank
üInterest Rate Swaps
üCurrency Swaps
Specific Areas
ØSwap Market Quotations
ØVariations of Basic Currency and Interest Rate
Swaps
ØRisks of Interest Rate and Currency Swaps
ØSwap Market Efficiency
ØAbout Swaps in General
Definitions
q In a swap, two counterparties
agree to a contractual
arrangement wherein they agree
to exchange cash flows at
periodic intervals.
▫ For example, a company might
ideally want to borrow in the
fixed rate market, but finds it
cannot do so at any reasonable
rate. It might therefore take out
a floating rate loan, and enter
into a swap contract under
which it pays amounts
equivalent to fixed rate interest
on a notional principal sum,
and receives amount equivalent
to floating rate interest on the
same notional principal.
Plain Vanilla Interest Rate Swap
• Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla" interest
rate swap.
▫ In this swap, 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.
▫ In a plain vanilla swap, the two cash flows are paid in the same
currency. The specified payment dates are called settlement
dates, and the time between are called settlement periods.
Because swaps are customized contracts, interest payments may
be made annually, quarterly, monthly, or at any other interval
determined by the parties.
Example
• On December 31, 2008, company A and company B enter into a
five-year swap with the following terms:
▫ Company A pays company B an amount equal to 6% per annum
on a notional principal of $20 million.
▫ Company B pays Company A an amount equal to one-year LIBOR
+ 1% per annum on a notional principal of $20 million.
▫ LIBOR, or London Interbank Offer Rate, is the interest rate
offered by London banks on deposits made by other banks in the
eurodollar markets. The market for interest rate swaps frequently
(but not always) uses LIBOR as the base for the floating rate.
▫ For simplicity, assume the two parties exchange payments
annually on December 31, beginning in 2009 and concluding in
2013.
Cash flows for a plain vanilla interest rate
swap
Fixed Rate: 6%
$ 20M*6% = $ 1,200,000

Company A Company B
LIBOR +1% = 5.33%+1 * $ 20
M = $1,200,000 = $ 1,266,000

• In a plain vanilla interest rate swap, the floating rate is usually


determined at the beginning of the settlement period.
• Normally, swap contracts allow for payments to be to avoid unnecessary
payments netted against each other
• Here, Company B pays $66,000, and Company A pays nothing. At no point
does the principal change hands, which is why it is referred to as a
"notional" amount.
Meaning of types
Two types of interest rate swaps
• Currency swap
▫ The plain vanilla currency swap involves exchanging
principal and fixed interest payments on a loan in one
currency for principal and fixed interest payments on a
similar loan in another currency.
▫ Unlike an interest rate swap, the parties to a currency
swap will exchange principal amounts at the beginning
and end of the swap.
▫ The two specified principal amounts are set so as to be
approximately equal to one another, given the exchange
rate at the time the swap is initiated.
CASH FLOWS FOR A PLAIN VANILLA
CURRENCY SWAP, STEP 1.
Principal : $50 million
Company C Company D
(US – (European-
based) base)
Principal : $40 million

Company C, a U.S. firm, and Company D, a European firm, enter into a five-
year currency swap for $50 million. Assume the exchange rate at the time is
$1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms will
exchange principals. So, Company C pays $50 million, and Company D pays
Euros 40 million. This satisfies each company's need for funds denominated in
another currency (which is the reason for the swap).
CASH FLOWS FOR A PLAIN VANILLA
CURRENCY SWAP, STEP 2
Interest: € 40 M* 3.50%
Company C Company D
(US – (European-
based) base)
Interest: $50 M*8.25%
The agreed-upon dollar-denominated interest rate is 8.25%, and the
euro-denominated interest rate is 3.5%. Thus, each year, Company C
pays € 40,000,000 * 3.50% = €1,400,000 to Company D. Company D
will pay Company C $50,000,000 * 8.25% = $4,125,000. As with
interest rate swaps, the parties will actually net the payments against
each other at the then-prevailing exchange rate. If, at the one-year
mark, the exchange rate is $1.40 per euro, then Company D's
payment equals $1,960,000, and Company C would pay the
CASH FLOWS FOR A PLAIN VANILLA
CURRENCY SWAP, STEP 3
Principal: € 40 M
Company C Company D
(US – (European-
based) base)
Principal : $50 M
The agreed-upon dollar-denominated interest rate is 8.25%, and the
euro-denominated interest rate is 3.5%. Thus, each year, Company C
pays € 40,000,000 * 3.50% = €1,400,000 to Company D. Company D
will pay Company C $50,000,000 * 8.25% = $4,125,000. As with
interest rate swaps, the parties will actually net the payments against
each other at the then-prevailing exchange rate. If, at the one-year
mark, the exchange rate is $1.40 per euro, then Company D's
payment equals $1,960,000, and Company C would pay the
Size of the Swap Market -
2008
• The notional amounts outstanding of over-the-
counter (OTC) derivatives continued to expand
in the first half of 2008.
• Notional amounts of all types of OTC contracts
stood at $683.7 trillion at the end of June, 15%
higher than six months before.
• The average growth rate for outstanding CDS
contracts over the last three years has been
45%. In contrast to CDS markets, markets for
interest rate derivatives and FX derivatives both
recorded significant growth.
Source: http://www.bis.org/publ/otc_hy0811.htm
Size of the Swap Market -
2008
• A Credit Default Swap
(CDS) is like an
insurance contract.
• In principle, it lets
someone who wants to
own a company's bonds
but doesn't want to risk
the company defaulting
buy insurance from
someone else, who is
willing to pay the buyer
of CDS protection the
face value of the bond if
a default happens.
• http://db.riskwaters.com/public/showPage.html?page=113
Swap and forex operations
in India
• The Indian foreign
exchange market has
grown significantly in the
last several years.
• The daily average
turnover has gone up from
about USD 5 billion per
day in 1998 to more than
USD 50 billion per day in
2008.
• There is also evidence of
growing merchant
turnover reflecting the
huge increase in external
transactions.
• The Total Turnover forex
operation between April
Currencies of the Swap
Market
• The most
popular
currencies are:
– U.S. dollar
– Japanese yen
– Euro
– Swiss franc
– British pound
sterling
The Swap Bank
The Swap Bank
• A swap bank is a • The swap bank
general term to can serve as
describe a either a broker or
financial a dealer.
institution that – As a broker, the
facilitates swaps swap bank
between matches
counterparties. counterparties but
does not assume
• They are the any of the risks of
market-makers in the swap.
most cases – As a dealer, the
swap bank stands
ready to accept
either side of a
An Example of an Interest
Rate Swap
“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.
– 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
An Example of an Interest
Rate Swap
• Firm B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a
five-year economic life.
– Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
– Alternatively, firm B can raise the money by
issuing 5-year floating-rate notes at LIBOR + ½
percent.
– Firm B would prefer to borrow at a fixed rate.
An Example of an Interest
Rate Swap
The borrowing opportunities of
the two firms are:
An Example of an Interest
Rate Swap 103/8%
Swap
Bank A
Bank
LIBOR -1/8%

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
An Example of an Interest
Rate Swap 103/8%
10.0%
Swap
Bank A
Bank
LIBOR -1/8%

½% of $10,000,000 = $50,000. That is quite a cost savings per year for 5 years.

Here’s what’s 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 – ½ % which is ½ % better
than they can borrow floating without a swap.
An Example of an Interest
Rate Swap 10½%
Swap Company
Bank B
LIBOR - ¼%

The swap bank makes this offer to company B: You pay us 10½% per year
on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on
$10 million for 5 years.
Here’s what’s in it for B:

10½%
+½%
Swap Company
Bank B
LIBOR - ¼%

They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½
+ (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow
floating.

½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years.
An Example of an Interest
Rate Swap
103/8% 10½%

Swap Company
Bank A Bank B
LIBOR -1/8% LIBOR - ¼%

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8


The swap bank makes money too.
10 ½ - 10 3/8 = 1/8
¼% of $10 million = $25,000 per year for 5 years. ¼
An Example of an Interest
Rate Swap
The swap bank makes ¼%
103/8% 10½%

Swap Company
Bank A Bank B
LIBOR -1/8% LIBOR - ¼%

A saves ½% B saves ½%
An Example of a
Currency Swap
• 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.
– 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
An Example of a
Currency Swap
• If they can find a British MNC
with a mirror-image 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
Example: 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 other’s
country of the same size. Their borrowing
opportunities are given in the table below.
A Currency Swap

$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
A Currency Swap
A’s net position is to borrow at £11%
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
A saves £.6%

11.6
%
A Currency Swap
B’s net position is to borrow at $9.4%
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
B saves $.6%

10.0
%
A Currency Swap
The swap bank makes money too:
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
1.4% of $16 million financed with 1% of £10 million per year for 5 years
At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.
The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).
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.
• In the above example, company B is
less credit-worthy than bank A, so they
probably would have gotten less of the
QSD, in order to compensate the swap
Comparative Advantage
as the Basis for Swaps
A is the more credit-worthy of the
A pays
two 2% less to borrow in dollars than B
firms.
A pays .4% less to borrow in pounds than B:

A has a comparative advantage in


borrowing in dollars.
B has a comparative advantage in borrowing
Comparative Advantage
as the Basis for Swaps
B has a comparative advantage in
borrowing in to
B pays 2% more £. borrow in dollars than A

B pays only 0.4% more to borrow in pounds than A:


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.
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 bid-ask spread.
• For example, 6.60 — 6.85 means the swap
bank will pay fixed-rate Euro at 6.60%
against receiving dollar LIBOR or it will
receive fixed-rate Euro payments at 6.85%
Variations of Basic Currency
and Interest Rate Swaps
• Currency Swaps
– fixed for fixed
– fixed for floating
– floating for floating
– amortizing
• Interest Rate Swaps
– zero-for floating
– floating for floating
• For a swap to be possible, a QSD
must exist. Beyond that, creativity
is the only limit.
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.
• Basis Risk
– If the floating rates of the two
counterparties are not pegged to the
same index.
• Exchange rate Risk
– In the example of a currency swap
given earlier, the swap bank would be
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.
Mismatch Risk
– It’s hard to find a counterparty that wants
to borrow the right amount of money for
the right amount of time.
Sovereign Risk
– The risk that a country will impose
exchange rate restrictions that will
interfere with performance on the swap.
Pricing a Swap
A swap is a derivative security
so it can be priced in terms of
the underlying assets:
How to:
– Plain vanilla fixed for floating swap
gets valued just like a bond.
– Currency swap gets valued just like
a nest of currency futures.
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
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
Thank you
Web sites and Books
Used:
International Financial Management: Eun and Resnick
http://www. investopedia.com
http://www.bba.org.uk/public/libor/
http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?