21-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger

21-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by VineySlides prepared by Anthony Stanger

Chapter 21

Interest Rate Swaps, Currency Swaps and Credit Default Swaps

Websites:www.bis.org

www.afma.com.au

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by VineySlides prepared by Anthony Stanger

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Learning Objectives• Describe the nature of a swap and explain the structure

and operation of vanilla and basis interest rate swaps• Understand the importance of the interest rate swap

market• Examine the structure of a cross-currency swap and

how they can be arranged• Explain the rationale for the cross-currency swap

markets• Introduce the concepts and parties to credit default

swaps• Consider the risks for an intermediary, or a

counterparty, to a swap


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Chapter Organisation

21.1 Interest Rate Swaps

21.2 Rationale for the Existence of Interest Rate Swaps

21.3 Currency Swaps

21.4 Rationale for the Existence of Currency Swaps

21.5 Credit Default Swaps

21.6 Credit and Settlements Risks Associated with Swaps

21.7 Summary


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• Notional value of swap market transactions– Australian market—about AUD36,013 billion– International markets—about USD381,829 billion

• Swaps may be used to hedge interest risk and exchange rate risk

• Swaps also enable investors and borrowers to obtain a lower cost of funds or a higher yield


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21.1 Interest Rate Swaps (cont.)

• Organised between borrowing parties

• The two parties swap their interest payment obligations

• No transfer of the principal amount

• Both parties benefit from the swap

• Example: Table 21.1 outlines the current cost of funds for two borrowers– Firm A has a credit advantage in both markets


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• Strategy

– Firm A borrows in a fixed market, where it has comparative advantage (i.e. 12%)

– Firm B borrows in another market (i.e. floating) at BBSW + 1.70%.

– One possible direct swap arrangement negotiable between firms A and B

B pays A a fixed rate of 13.60% A pays B a floating rate of BBSW + 1.70% Figure 21.1 illustrates the flow of funds and benefits of this

interest rate swap


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• The majority of swaps require the involvement of an intermediary, e.g. merchant bank, that often seeks an offsetting ‘matched swap’

– It enters into opposite swap transactions to offset its net swap exposure, making a profit through a spread between the rates

– Figures 21.3 and 21.4 in the textbook illustrate intermediated interest rate swaps


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21.3 Currency Swaps




21.7 Summary


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21.2 Rationale for the Existence of InterestRate Swaps

• Reasons why the use of interest swaps has continued to grow

– Lowering the cost of funds (comparative advantage)

– Access gained to otherwise inaccessible debt markets

– Hedge interest rate risk exposures

– Profit margins locked in on economic transactions


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21.2 Rationale for the Existence of Interest Rate Swaps (cont.)

• Lowering the net cost of funds (comparative advantage)

– For a comparative advantage to exist, the advantage in the fixed market must be different from that in the floating market (i.e. different risk premium)

– Why does this occur? Segmentation between floating and fixed debt markets

• Some types of institutions lend more heavily in floating markets (commercial banks) while others lend more heavily in fixed markets (life insurance offices, superannuation funds and unit trust funds)


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• Lowering the net cost of funds (comparative advantage) (cont.)

– Despite exploitation of arbitrage opportunities that has reduced the possibility of profitable swap arbitrage arrangements, the interest rate swap market continues to grow for other reasons

– Table 21.2 indicates how interest rates in the two markets might adjust to remove the possibility of a profitable swap based on comparable advantage


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• Gaining access to otherwise inaccessible debt markets

– Banks generally prefer lending at floating rates because it allows them to maximise their spread on loans when interest rates are changing

Despite this, banks may provide limited funding to a client at fixed rates with the balance lent at floating rates

– Corporate borrowers able to issue fixed interest bonds must have a good credit rating

Other borrowers obtain floating-rate funds from banks and use a swap to obtain a net fixed rate cost of funds


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• Hedging existing interest rate exposures

– Example: a firm has an existing floating-rate loan and is concerned that floating rates will rise

Strategy: the firm is able to synthesise (create) a fixed-cost loan by:

• paying a fixed rate to the swap counterparty• receiving a floating payment from the counterparty

Effect: if floating rate rises, firm’s payments to floating-rate lenders increases, but are matched by increase in receipts from swap counterparty, and payment to counterparty remains fixed


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• Hedging existing interest rate exposures (cont.)

– Example: a firm has an existing fixed-rate liability and is concerned floating rates will fall

Strategy: the firm is able to synthesise (create) a floating-rate cost of funds by:

• paying a floating rate to the swap counterparty• receiving a fixed-rate payment from the counterparty

Effect: fixed-rate payment received from counterparty is used to pay fixed-rate lenders, leaving the firm to make only a net floating-rate payment


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• Locking in profit margins on economic transactions

– A manufacturer or provider of fixed-price goods or services is exposed to any movements in variable costs (such as floating-rate funds) and has an incentive to enter into a swap

– Locking in a net fixed-costs fund locks in a fixed-profit margin for the firm


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• Swaps in practice

– In reality more complex swap arrangements exist than the previous examples

– Swaps are likely to be more dynamic Existing swaps will be monitored and actively managed Swaps may be reversed when current interest rates change, or

when interest rate expectations alter


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21.3 Currency Swaps




21.7 Summary


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21.3 Currency Swaps

• Two parties exchange debt denominated in different currencies

• Interest payments are exchanged

• Principals are exchanged at the beginning of an agreement and then re-exchanged at the conclusion of the agreement, usually at the same exchange rate


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21.3 Currency Swaps (cont.)

• Example– Table 21.3 indicates there is a cost-of-funds benefit from the

currency swap agreement of 0.50% per annum


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• Example (cont.)

– Assuming X prefers USD and Y prefers AUD, a fixed-to-fixed currency swap strategy could be the following:

Commencement of swap: currency swap• X borrows AUD20 million and transmits it to Y• Y borrows USD15.2 million and transmits it to X• Exchange rate is AUD/USD0.7600• X and Y agree on the interest payment swap rates


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• Example (cont.)

Interest payments• X pays 11.50% in USD to Y• Y pays 9.75% in AUD to X• Both secure a cost of funds at 0.25% lower than if they had

borrowed their preferred currency in their own right


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• Example (cont.)

Maturity of swap: currency re-exchange• At conclusion of the swap agreement, principal amounts are re-

exchanged along with the final interest payments– X transmits USD15.2 million to Y– Y transmits AUD20 million to X– At original exchange rate of AUD/USD0.7600

– Effect

While FX risk is eliminated, both X and Y will need to obtain internally or purchase the relevant interest and principal amounts at the current exchange rate when due

• A notional FX gain or loss can still be made


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21.3 Currency Swaps




21.7 Summary


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• Currency swaps exist for the same reasons interest rate swaps are popular:

– Lowering the net cost of funds– Gaining access to otherwise inaccessible debt markets– Hedging interest rate (FX) risk exposures– Locking in profit margins on economic transactions


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– Lowering the net cost of funds Borrowers may obtain better terms by borrowing in different

markets, including those denominated in foreign currencies; thus creating a need for currency swaps

– Hedging FX risk Two companies can follow their comparative advantage in the

debt markets and enter a currency swap


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21.4 Rationale for the Existence of Currency Swaps (cont.)


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21.3 Currency Swaps




21.7 Summary


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• Credit risk– Possibility that an obligor (borrower) will not meet a future

financial commitment (interest or principal) to a lender

• Credit default swap (CDS)– An agreement transferring credit risk from the protection

buyer to the protection seller on the payment of a premium Premium paid by the protection buyer is typically a number of

basis points relative to the credit protection amount


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21.5 Credit Default Swaps (cont.)

• Credit default swap (CDS) (cont.)

– CDS protection seller Institution that writes a CDS, accepting the credit risk of a

reference entity and undertaking to compensate the protection buyer if a specified credit default event occurs

• Typically, insurance companies, banks, investment managers and hedge funds that have identified a capacity to accept higher levels of credit risk exposure in their balance sheets

– Reference entity An obligor (borrower) with a debt or loan obligation to the CDS

protection buyer, e.g. a corporation or government


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– CDS protection buyer Lender or investor buying a CDS to transfer risk associated

with a reference entity• Typically, banks, portfolio managers and multinational

corporations that have identified a need to manage a credit risk exposure in their balance sheets

– The CDS specifies a credit default event E.g. bankruptcy, obligation acceleration, obligation default, cash

payment failure, repudiation or moratorium of debt by a nation state


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– In the event of credit default by the reference entity the most common forms of settlement are:

Physical settlement• Protection buyer delivers the agreed notional value of the debt of

the reference entity to the protection seller and receives payment of that amount by the protection seller

Cash settlement• Protection seller pays a net cash amount to the protection buyer,

usually based on the difference between the face value and the current market value of the underlying reference debt instruments


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21.3 Currency Swaps




21.7 Summary


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21.6 Credit and Settlements Risk Associated with Swaps

• Credit risk

– Most swaps are through an intermediary

– Intermediary is at risk if one of the two counterparties defaults

– Intermediary is exposed to interest rate risk (i.e. uncertainty associated with fixed and floating markets)

Exposure of intermediary limited to the difference between what a firm would have paid to, and received from, the intermediary

– Also occurs with currency swaps where a party defaults on the payment of interest or principal


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21.6 Credit and Settlements Risk Associated with Swaps (cont.)

• Settlements risk

– With currency swaps settlements risk occurs if one party settles an obligation within its time zone and the other party later defaults within a different time zone

Significant time zone differentials can create this timing difference


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21.3 Currency Swaps




21.7 Summary


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21.7 Summary

• Swaps facilitate the exchange of specified cash flows– Interest rate swaps are used to:

reduce the cost of borrowing manage existing interest rate exposures

– Currency swaps are used when an interest rate swap involves borrowing in different currencies

Allow the management of interest rate and FX risk exposure Currency swaps differ from interest rate swaps in that the

principal amounts raised by the two borrowers are swapped at commencement and re-exchanged at the end of the agreement

Documents

21-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger