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

Company B

• • •

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 (US – based)
Principal : $40 million

Company D (Europeanbase)

Company C, a U.S. firm, and Company D, a European firm, enter into a fiveyear 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 (US – based)
Interest: $50 M*8.25%

Company D (Europeanbase)

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 (US – based)
Principal : $50 M

Company D (Europeanbase)

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-thecounter (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

• The most popular currencies are:
– – – – – U.S. dollar Japanese yen Euro Swiss franc British pound sterling

Currencies of the Swap Market

The Swap Bank

The Swap Bank
• A swap bank is a general term to describe a financial institution that facilitates swaps between counterparties. • They are the market-makers in most cases • The swap bank can serve as either a broker or a dealer.

– 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

“Plain Vanilla” Interest Rate Swap.

An Example of an 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

• 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

An Example of an Interest Rate Swap
The borrowing opportunities of the two firms are:

An Example of an Interest Rate Swap
103/8%

Bank A
LIBOR -1/8%

Swap Bank

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%

Bank A
LIBOR -1/8%

Swap Bank

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 Bank
LIBOR - ¼%

Company B

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%

Swap Bank
LIBOR - ¼%

Company B

+½%

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%

Bank A
LIBOR -1/8%

Swap Bank
LIBOR - ¼%

Company B

The swap bank makes money too.
¼% of $10 million = $25,000 per year for 5 years.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼

An Example of an Interest The swap bank makes ¼% Rate Swap
103/8% 10½%

Bank A
LIBOR -1/8%

Swap Bank
LIBOR - ¼%

Company B

A saves ½%

B saves ½%

• 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. • They could borrow pounds in the international bond market, but pay a premium since they are not as
– This will give them exchange rate risk: financing a sterling project with dollars.

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

An Example of a Currency Swap

Example: a Currency Swap is a U.S.–based Consider two firms A and B: firm A
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 $8 $9.4

Firm A
£11

Swap Bank
£12

Firm B

£12

A Currency Swap
A’s net position is to borrow at £11%
$8 $8 $9.4

Firm A
£11

Swap Bank
£12

Firm B

£12

A saves £.6%

11.6 %

A Currency Swap
B’s net position is to borrow at $9.4%
$8 $8 $9.4

Firm A
£11

Swap Bank
£12

Firm B

£12

B saves $.6%

10.0 %

A Currency Swap
The swap bank makes money too:
$8 $8 $9.4

Firm A
£11

Swap Bank
£12

Firm B

£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 2% less to borrow in dollars than B two 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 borrow in dollars than A B pays 2% more £.

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

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.

Comparative Advantage as the Basis for Swaps

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%

• Currency Swaps
– – – –

Variations of Basic Currency and Interest Rate Swaps
fixed for fixed fixed for floating floating for floating amortizing

• Interest Rate Swaps • For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.
– zero-for floating – floating for floating

• Interest Rate Risk

Risks of Interest Rate and Currency Swaps

• Basis 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. – 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

• Exchange rate 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. – 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.

Credit Risk

Risks of Interest Rate and Currency Swaps

Mismatch Risk

Sovereign Risk

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?

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