1 HEDGING CURRENCY RISKS: SWAPS. 2 Currency and interest rate swaps A swap agreement between two parties commits each counterparty to exchange an amount

1

HEDGING CURRENCY RISKS: SWAPS

2

Currency and interest rate swaps

A swap agreement between two parties commits each counterparty to exchange an amount of funds, determined by a formula, at regular intervals, until the swap expires

In the case of a currency swap, there is an initial exchange of currency and a reverse exchange at maturity

3

Foreign currency swap

A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing.

A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency.

A “Plain Vanilla” Foreign Currency Swap is when two firms trade fixed-rate interest payments across currencies.

4

Dell

SFr

Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country…

“Plain-Vanilla” foreign currency swap

5

Nestle

SFr$

Nestle would like to borrow in Dollars to hedge its sales to the U.S...

SFr

Dell


6

But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms.

Nestle

SFr$ SFr

Dell


7

Nestle

I-Bank SFr$

But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them...

Nestle

SFr$ SFr

Dell


8

Dell Nestle

SFr$

…and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans...

$ Sfr

I-Bank

Dell Nestle

I-Bank SFr$

Nestle

SFr$ SFr

Dell


9

Dell Nestle

SFr$

…in return for making the payments in the foreign currency that exactly match the other firm’s obligations.

$ Sfr

Sfr $

I-Bank

Dell Nestle

I-Bank SFr$

Nestle

SFr$ SFr

Dell


10

I-BankI-Bank

Dell Nestle

SFr$

In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms.

$ Sfr

Sfr $

Dell Nestle

SFr$

Nestle

$

Dell


11

Comparative borrowing advantage

Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant.

One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty.

In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell. Nonetheless, a swap may be mutually advantageous.

12

Origins and underpinnings of the swap market

In the early 1980s, the currency swap evolved as a way to simplify and speed the exchange of currency cash flows between counterparties, and quickly gained popularity. the use of a swap lowers the transaction costs. as a new financial product, it was also not covered by any

accounting disclosure or security registration requirements.

13

Accidents in risk management

Corporate Sector

Organization Year Losses Contracts

Procter & Gamble 1994 $102 million Interest rate swap (U.S.)

Gibson Greetings 1994 $20 million Interest rate swap (U.S.)

Showa Shell 1993 $1.54 billion Foreign exchange (Japan)

Metallgesellschaft 1993 $1.3 billion Oil futures (Germany)

Allied Lyons 1991 $265 million Foreign exchange (U.K.) options

14

Public Agencies

Organization Year Losses Contracts

State of Wisconsin 1995 $95 million Interest rate swapsInvestment Board (U.S.)

Orange County 1994 $1.7 billion U.S. government (U.S.) securities

and interest rate derivatives

British Councils 1986 $900 million Interest rate swaps (U.K.) -1988

Accidents in risk management

15

The basic cash flows of a currency swap

Firms A and B can each issue a 7-year bond in either the US$ or SFr market.

Firm A enjoys an absolute advantage in both credit markets.

11.5%10%

5% 6%

Firm A Firm B

US$finance

SFrfinance

16

Firm A has a comparative advantage in borrowing US$, while

firm B has a comparative advantage in borrowing SFr.

Difference(A-B)

-1.5%

-1.0%

- 0.5%

By borrowing in their comparative advantage currencies and then swapping, lower cost financing is possible.

11.5%10%

5% 6%

Firm A Firm B

US$finance

SFrfinance


17

Together, A and B save 0.5%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.

10.75% (US$) [t 1 - t 7]

5.5% (SFr) [t 1 - t 7]

$ at t 7

SFr at t 7

$ at t 0

SFr at t 0

A

Borrows $at 10%

for 7 years

B

Borrows SFrat 6%

for 7 years


18

Other types of swaps

“Plain Vanilla” Interest (Fixed-for-Floating) Rate Swaps

One counterparty exchanges the interest payments of a floating-rate debt obligations for the fixed-rate interest payments of the other counterparty.

Currency-Interest Rate Swaps:

One counterparty exchanges the floating-rate debt service obligations of a bond denominated in one currency for the fixed-rate debt service obligations denominated in the other currency.

19

Currency swaps

What risks exist in entering into a swap and maintaining it? interest rate risk

exchange rate risk

credit risk

20

Example In 1998 several Korean banks refused to pay the American banks

hundreds of millions of dollars owed under deals involving currency swaps

Swap contracts were signed on the assumption that the underlying currency would remain stable.

SK Securities sued J.P. Morgan

J.P. Morgan sued SK Securities

SK Securities claimed J.P. Morgan missinformed its customers

When the baht started to fall, J.P. Morgan told its customers that the currency would soon stabilize and insisted his client has ample evidence to back its claims

21

The basic cash flows of a IR swap

10.5%9%

LIBOR+0.0%

LIBOR+0.5%

Firm A Firm B

Fixed-rate

finance

Floating-rate

finance

Firms A and B can each issue a 7-year US$ denominated bond in either fixed-rate or floating-rate terms.

Firm A enjoys an absolute advantage in both credit markets?

22

10.5%9%

LIBOR+0.0%

LIBOR+0.5%

Firm A Firm B

Fixed-rate

finance

Floating-rate

finance

Difference(A-B)

-1.5%

- 0.5%

- 1.0%

Firm A has a comparative advantage in the fixed-rate bond market, while firm B has a comparative advantage in the floating-rate bond market.

By borrowing in their comparative advantage markets and then swapping, lower cost financing is possible.


23

Together, A and B save 1%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.

A B

Borrows at9.0%fixed

for 7 years

Borrows atLIBOR + 0.50%

floatingfor 7 years

9.75%

LIBOR + .25

Interest payments to each other in years t 1

to t 7.


24

The pricing of swaps

The swap price should be based on the net present value of the expected future cash flows

In addition, numerous parity or arbitrage linkages among swap contracts aid in the determination of swap prices

25

Cu

rren

cy X

Cu

rren

cy Y

Fixed RateAsset or Liability

Floating RateAsset or Liability

Interest Rate Base

Cu

rren

cy o

f D

enom

inat

ion

Interest Rate Swap

Floating-F

loating Currency Sw

ap

D

Fix

ed-F

ixed

Cu

rren

cy S

wap

A Interest Rate Swap B

C

CrossCurrency

Interest RateSwap

Two currencies, X and Y, have both fixed-rate and floating-rate segments.

For example, with an interest rate swap in currency X (AB) and a fixed-fixed currency swap (AC), we can construct a cross currency interest rate swap (BC).

The pricing of swaps

Documents

1 HEDGING CURRENCY RISKS: SWAPS. 2 Currency and interest rate swaps A swap agreement between two parties commits each counterparty to exchange an amount