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14Chapter Fourteen

Interest Rate andCurrency Swaps

Chapter Objective:

This chapter discusses currency and interest rate

swa s, which are relativel new instruments for

hedging long-term interest rate risk and foreign

exchange risk.

14-0

Chapter Outline

Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps Types of Swaps

Size of the Swap Market

The Swap Bank

Swap Market Quotations

Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps


The Swap Bank


Interest Rate Swaps

Currency Swaps

Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps

Is the Swap Market Efficient?



















Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient?

14-1

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Definitions

In a swap, two counterparties agree to a

contractual arrangement wherein they agree to

exchange cash flows at periodic intervals.

There are two types of interest rate swaps:

Single currency interest rate swap

- -

interest rate swaps.

Cross-Currency interest rate swap

This is often called a currency swap; fixed for fixed rate debt

service in two (or more) currencies.

14-2


In 2007 the notational principal of:

Interest rate swaps was $271.9 trillion USD.

Currency swaps was $12 trillion USD

The most popular currencies are:

U.S. dollar

Euro

Swiss franc

British pound sterling

14-3

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Global FX Market Share: By Instruments

14-4

The Swap Bank

A swap bank is a generic term to describea financial institution that facilitatesswaps between counterparties.

The swap bank can serve as either abroker or a dealer. s a ro er, t e swap an matc es counterpart es ut

does not assume any of the risks of the swap.

As a dealer, the swap bank stands ready to accept eitherside of a currency swap, and then later lay off their risk,or match it with a counterparty.

14-5

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Interest Rate Swaps: Basics Three Parties

A fixed rate payer, who wants to swap to floating rate

A floating rate payer, who wants to swap to fixed rate

An intermediary, the Swap Bank, who arranges the swap

Receives floating rate form the fixed rate payer, and takes over

the fixed rate payment on his/her behalf

Receives fixed rate form the floating rate payer, and takes overthe floating rate payment on his/her behalf

14-6

Receives a fee from both for arranging the deal

The interest payments of the first two parties change

The Notional Principle does not change

Interest Rate Swap QuotationsEuro- Sterling Swiss franc U.S. $

Bid Ask Bid Ask Bid Ask Bid Ask

The convention is to quote against U.S. dollar LIBOR.

1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57

2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94

3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13

4 year 3.06 3.09 5.12 5.17 1.73 1.81 4.25 4.28

5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39

3.823.85 means the swap bank will pay

fixed-rate euro payments at 3.82%

against receiving dollar LIBOR or it will

6 year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50

7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58

8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66

9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72

10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79

rece ve xe -ra e euro paymen s a

3.85% against paying dollar LIBOR

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Swap Quotations3.823.85 means the swap bank will pay fixed-rate

euro payments at . aga nst rece v ng o ar

LIBOR or it will receive fixed-rate euro payments at

3.85% against paying dollar LIBOR

Swap FirmFirm 3.82%3.85%

an$LIBOR $LIBOR

While most swaps are quoted against flat dollar

LIBOR, off-market swaps are available where

one party pays LIBOR plus or minus some number.14-8

Example of an Interest Rate Swap

Consider firms A and B;

each firm wants to borrow

Fixed Floating

A 5% LIBOR.

B 5.50% LIBOR + .20%

Firm A wants to finance an interest-rate-sensitive asset andtherefore wants to borrow at a floating rate.

A has good credit and can borrow at LIBOR

- -

therefore wants to borrow at a fixed rate.B has less-than-perfect credit and can borrow at 5.5%

The swap bank quotes 5.15.2 against dollar LIBOR for a

3-year swap.14-9

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Firm

A

5.10%

LIBOR

Swap

Bank

If Firm A borrows from their bank at 5.0% fixed

and takes up the swap bank on their offer of

BankX

5.15.2 they can convert their fixed rate 5%

debt into a floating rate debt at LIBOR 0.10%

As all-in-cost:

= 5.0% + LIBOR 5.10% = LIBOR 0.10%14-10


Firm

B

5.20%Swap

Bank LIBOR

If Firm B borrows floating from their bank at

LIBOR + 0.20% and takes up the swap bank on

Bank

Y

their offer of 5.15.2 they can convert their

floating rate debt into a fixed rate debt at 5.40%

Bs all-in-cost:

= LIBOR + LIBOR + 0.20% + 5.20% = 5.40%14-11

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Firm

B

Firm

A

5.20%5.10%

LIBOR

Swap

Bank LIBOR

The Swap Bank makes 10 basis points on the deal:

The Swap Banks all-in-cost:

= LIBOR + LIBOR 5.20% + 5.10% = 0.10%

14-12


Firm

B

Firm

A

5.20%5.10% Swap

BankLIBOR LIBOR

The notional size is $40 million.

The tenor is for 3 ears.

Bank

X

Bank

Y

A earns $40,000 per year on the swap.

B earns $40,000 per year on the swap.

Swap Bank earns $40,000 per year.

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Using a Swap to Transform a Liability

Firm A has transformed a fixed rate liabilityinto a floater.

A is borrowing at LIBOR .10%

A savings of 10 bp

Firm B has transformed a floating rateliability into a fixed rate liability.

s orrow ng at .

A savings of 10 bp

The Swap Bank also generates a profit of 10 bp

14-14

The QSD The Quality Spread Differential represents the potential

gains from the swap that can be shared between the

counterparties and the swap bank.

Fixed Floating

A 5.00% Libor

B 5.50% Libor + 0.20%

QS 0.50% 0.20% 0.30%

The 0.30% QSD is

the difference

between the two

quality spreads

14-15

In this case, the 0.30%, or 30 bp, QSD is equally sharedbetween the two counterparties and the Swap Bank.

But there is no reason to presume that the gains will beshared equally.

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What about the Principal?

In our lain vanilla interest-onl interest

rate swap just given, we did not mention

swapping the Notational Principal.

It could be the case that firm A exchanged

rinci al with their lender Bank X and

firm B exchanged principal with their

outside lender, Bank Y.

14-16

Cash Flows of an Interest-Only Swap: T = 0

Firm

B

Firm

A

Swap

Bank

Bank

X

Bank

Y

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Cash Flows of an Interest-Only Swap: T = 1Assume LIBOR = 3%

Firm

B

Firm

A

Swap

Bank$1,200,000 $1,200,000

$2,040,000 $2,080,000


BankX

BankY

,

borrowing at LIBOR = 3%.

B saves $40,000 per year relative toborrowing at 5.5%.

14-18


$1,600,000

Firm

B

Firm

A

$2,040,000 Swap

Bank $1,600,000

$2,080,000


Bank

X

Bank

Y

,


B saves $40,000 per year relative to

borrowing at 5.5%.

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$2,000,000

Firm

B

Firm

A

$2,040,000 Swap

Bank $2,000,000

$2,080,000


BankX

BankY

,


B saves $40,000 per year relative toborrowing at 5.5%.

14-20

Currency Swap Agreement

Two counterparties use a Swap Bank to:

Convert a liability denominated in one currencyinto a liability denominated in another currency

Swap principal in the beginning

Swap interest during the period

14-21

Equivalent to a series of forward contracts

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Example of an Currency Swap

Firm A is a U.S. MNC and wants to

borrow 40 million for 3 years.

$

A $7% 6%

borrow $60 million for 3 yearsB $8% 5%

Firm A wants finance euro denominated asset in Italy andtherefore wants to borrow euro.

A can borrow euro at 6%

rm wants nance a o ar enom nate asset antherefore wants to borrow dollars.

B can borrow dollars at 8%

The current exchange rate is $1.50 = 1.00

14-22

Comparative Advantageas the Basis for Swaps

A has a comparative advantage in borrowing in

$

A $7% 6%

dollars.

B has a comparative advantage in borrowing in

euro.

B $8% 5%

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Example of a Currency SwapSuppose that the Swap Bank publishes these quotes.The convention is to quote against U.S. dollar LIBOR.

- . .

Bid Ask Bid Ask

3 year 5.00 5.20 7.00 7.20

Firm A wants finance euro-denominated

$

A $7% 6%

B $8% 5%

asset n ta y an wants to orrow euro.

A can borrow euro at 6% or they can

borrow euro at 5.2% by using acurrency swap.

14-24

Example of a Currency Swap

Euro- U.S. $

Bid Ask Bid Ask

$

A $7% 6%

(The convention is to quote against U.S. dollar LIBOR.)

$7.0%

5.00 5.20 7.00 7.20 B $8% 5%

Firm

A 5.2%

Swap

BankBank

X

LIBOR

$7.0%

$60m

Suppose that Firm A borrows$60m at $7%; trades for at spot.

FOREX Market

LIBOR$60m

40m

Firm A then enters in to 2

fixed for floating swaps.14-25

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Example of a Currency Swap

Euro- U.S. $

Bid Ask Bid Ask

$

A $7% 6%

(The convention is to quote against U.S. dollar LIBOR.)

$7.2%

5.00 5.20 7.00 7.20 B $8% 5%

Firm

B5.0%

Bank

YSwap

Bank

LIBOR

40m

5%

Suppose that Firm B borrows

40m at 5%, trades for $.FOREX Market

LIBOR 40m

$60m

Firm B then enters in to 2

fixed for floating swaps.14-26

Example of a Currency SwapSwap Bank earns 40 bp per year (20bp in $ and 20bp in ).

Firm

B

Firm

A

$7.0% $7.2%

5.2%

Swap

Bank 5.0%

The notional size is $60m for 3 years.

Firm A earns 80 bp per year on the swap and

Bank

X

Bank

Y

hedges exchange rate risk.Firm B earns 80 bp per year on the swap

and hedges exchange rate risk.

14-27

Swap Bank earns 40 bp per year

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Cash Flows of the Swaps: T = 0

Firm

B

Firm

A

Swap

Bank

BankX

BankY

Foreign ExchangeSpot Market

14-28


$1.8m$1.8m

Assume LIBOR = 3%

Firm

B

Firm

A

Swap

Bank

. m

2m

$1.8m

. m

2.08m

$1.8m

Swap bank earns 80,000 + $120,000

BankX

BankYFirm As all-in-cost

2.08m or

5.2% of 40m

Firm Bs all-in-cost

$4.32 or

7.2% of $60m

or .00240m + .002$60m per year.

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$2.4m$2.4m

Assume LIBOR = 4%

Firm

B

Firm

A

Swap

Bank

4.32m

2m

$2.4m

4.2m

2.08m

$2.4m

Bank

X

Bank

Y

14-30


$3m$3m

Assume LIBOR = 5%

Firm

B

Firm

A

Swap

Bank

.

2m

$3m

.

2.08m

$3m

BankX

BankY

Foreign Exchange

Forward Market14-31

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Example of a Direct Currency Swap

$

A $7% 6%

If firms A and B knew and trusted each

other, they could theoretically cut out the

swa bank:Firm

B

Firm

A

$7.0%

5.0%

The problem is of course that the swap

B $8% 5%

BankX

BankY

dealer) and providing a servicethats

why they get paid.Signing 1 contract is less work than 4.

14-32

Equivalency of Currency SwapDebt Service Obligations

$

A $7% 6%

B $8% 5%

rate and the 7% dollar rate.

This is reasonable since these rates are, respectively, thebest rates available for each counterparty who is well known

in its national market.(1 + i )t

t = 0

(1 + i)t

F1 = $1.50(1.07)1

(1.05)1

14-33

F2 = $1.50(1.07)2

(1.05)2 F3 = $1.50

(1.07)3

(1.05)3

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Year 0 1 2 3

S0 F1 F2 F3

Swap: A Series of Forward Contracts

FX 1.50 1.5142 1.5577 1.5874

IRR CF0 CF1 CF2 CF3

7.00% $60.00 $4.20 $4.20 $64.20

. . . . .

5.00% 40.00 2.00 2.00 42.00

7.00% $60.00 $3.06 $3.12 $66.6714-34

IRR 0 1 2 3

7.00% $60.00 $4.20 $4.20 $64.20

5.00% 40.00 2.75 2.70 40.44

The swa bank could borrow $60m at 7% and use a set of 3

forward contracts to redenominate their bond as a 5% euro

bond.

40m = $60m1.00

$1.502.7477m = $4.20m $1.50

(1.05)

(1.07)

= (1.07)2

14-35

. . .

(1.05)2

40.4446m = $64.20m $1.50 (1.05)3

(1.07)3

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IRR 0 1 2 3

5.00% 40.00 2.00 2.00 42.007.00% $60.00 $3.06 $3.12 $66.67

forward contracts to redenominate their bond as a 7% dollar

bond.

$60m = 40m $1.50 $3.06m = 2m $1.50 (1.05)

(1.07)

2

$3.12m = 2m $1.50 (1.05)2

.

$66.67m = 42m $1.50(1.05)3(1.07)3

14-36

Equivalency of Currency Swap DebtService Obligations

The ability to hedge with covered interest arbitrage

is where the swap bank found the 5% and $7%

ratesEuro- U.S. $

Bid Ask Bid Ask

5.00 5.20 7.00 7.20

Competition from other swap banks will keep theirspreads from getting too widethe theoretical limit

is 200 basis points total. (See QSD on next slide.)

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The QSD: Currency Swap

The QSD is calculated as the difference between

the spreads in the two countries

QSD = 1 (-1) = 2% = 200 bp

A & B earn 80 bp each, while Swap Bank earns 40

bp

A 7% 6%

B 8% 5%

QSD 1% 1%

14-38

Risks of Interest Rateand 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 hasan unhedged position.

Basis Risk If the floating rates of the two counterparties are not

.

Exchange rate Risk In the example of a currency swap given earlier, the

swap bank would be worse off if the pound appreciated.

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Risks of Interest Rate

and Currency Swaps (continued)

Credit Risk This is the major risk faced by a swap dealerthe risk

that a counter party will default on its end of the swap.

Mismatch Risk Its hard to find a counterparty that wants to borrow the

right amount of money for the right amount of time.

overe gn s The risk that a country will impose exchange rate

restrictions that will interfere with performance on theswap.

14-40

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

,

well as the swap dealer) through financing that ismore suitable for their asset maturity structures.

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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

14-42

Sample Interest Rate Swap Problem A is a credit-worthy firm

A can borrow at 8% fixed

A can borrow at flat LIBOR

A prefers to borrow floating

B is a less-credit-worthy firm

B can borrow at 9% fixed

B can borrow at LIBOR + %

Fixed Floating

A 8% LIBOR

B 9% LIBOR +

B prefers to borrow fixed Both firms want a 10-year maturity

Devise a swap that is mutually beneficial for A and B. Follow the convention of pricing against flat LIBOR.

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Fixed FloatingA 8% LIBOR

B 9% LIBOR +

QSD = 1% % = %14-44

Sample Currency Swap Problem A is an Italian firm A can borrow in euro at 5% fixed

A prefers to borrow in dollars but faces 8% cost

B is an American firm B can borrow in dollars at 7%

B now prefers to borrow in euro but faces 6% cost

-

Devise a feasible swap that eliminates exchangerate risk for A and B

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$

A 8% 5%

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

.

The First Major Currency Swap: 1981 IBM/WorldBank : IBMs Perspective

IBM wanted to call its Deutsche Mark (DEM) and Swiss Franc

(CHF) debt: the USD had appreciated considerably and the DMand SF interest rates had also gone up. Due to a depreciation

,

a large foreign exchange gain, but only if it could eliminate itsDEM and CHF liabilities and lock in the gain.

But this would be costly:

Exchange transaction costs when IBM buys DEM and CHF

Call premium: IBM has to pay more than the DEM and

CHF face value Issuing costs when IBM issues new USD bonds.

Capital gains taxes on realized gain

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The First Major Currency Swap: 1981 IBM/WorldBank: World Banks Perspective

The World Bank (WB) wanted to borrow DEM and CHF to lendto its customers.

Though it wanted to lend in DM and Swiss francs, the bank was

borrow more in these two currencies at a favorable rate.

The WB was raising most of its funds in DEM (interest rate = 12%)and Swiss francs (interest rate = 8%).

It did not want to borrow in USD (interest rate = 17)

Note that:

IBM wanted to retire CHF and DEM bonds (at a rather high cost)

WB wants to issue CHF and DEM bonds (also at a cost).

To avoid most of these costs, IBM and WB agreed that WB would take

over IBMs foreign debt instead

Salmon Brothers arranged the Swap

The Basic Swap Agreement

WB borrows USD instead of DEM, CHF. With the proceeds it buys

WB undertakes to deliver to IBM the DEM and CHF necessary

to service IBMs old DEM and CHF loans,

IBM promised to provide the WB with the USD needed

to service the WB's (new) USD loan;

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Overview

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f55 ER Ch14 Swaps