FI - Overview of Cross Currency Swaps via Swap Pricer

Overview of Cross Currency Swaps via Swap Pricer ([email protected])

Last updated on 23th Jan 2014

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Overview of Cross Currency Swaps via Swap Pricer

Agenda

1. What is a Cross Currency Swap, CRS/CCS ?

2. How to get indicative data on CRS/CCS rates ?

3. How to price a new CRS/CCS deal ?

4. How to mark-to-market an existing CRS/CCS deal ?

5. Conclusion

What is a Cross Currency Swap ?

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1. Loans : to borrow at a lower interest rate ?

Interest Rate Swap may give you the flexibility to switch from fixed to float,

or vice versa, for a single currency.

But, Cross Currency Swap provides another degree of freedom.

The currency to pay may be different from the currency to be received.

Interest Rate Swap, IRS

USD

floating

rate

USD

Fixed

rate

Cross Currency Swap, CRS or CCS

USD

floating

rate

USD

Fixed

rate

KRW

floating

rate

KRW

Fixed

rate

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1.1 Cross Currency Swap Basics

A Cross Currency Swap (EUR/JPY) has the features of an Interest Rate Swap while

giving each counterparty access to a different foreign currency.

For example,

Currency principal amounts may be exchanged at the outset and re-exchanged at

maturity at the same Exchange Rates.

As a result, Exchange Risk on the principal amounts is eliminated, while retaining

1. the Interest Rate Exposure and

2. Currency Exposure on the Interest flows and

3. on the Net Result of any transaction that has been closed out prior to Maturity.

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1.2 Different Combinations

These cashflows (interest payments) could be:

1. Fixed against floating

2. floating against floating

3. Fixed against Fixed

4. Linked with the Returns on an Asset

(example, Standard Chartered Bank’s Islamic Swap)

KRW Principal

KRW Principal

Floating KRW Interest payments

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1.3 Cross Currency Swap, graphically

USD fixed rate

5.86%

KRW floating rate

KRW fixed rate

3.7%

USD floating rate

“Middle Earth”

KRW Zero coupon curve

or discount factors

USD Zero coupon curve

or discount factors

Currency

Basis swap

spread

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1.4.1 Fixed/Fixed Cross Currency Swap vs FX Swap

Notional : USD 1 million

: KRW 920 million

Tenor : 5 years

FX ref : 920 (same rate : begin & end)

USD fixed : 4.9%

KRW fixed : 5.4%

Corp pays KRW 5.4%

Corp receive USD 4.9%

Corp receives KRW 920 mio

Corp pays USD 1 mio

Swap

Bank Corporate

Corp pays KRW 920 mio

Corp receives USD 1 mio

Notional : USD 1 million

: KRW 920 million

Tenor : 5 years

USD fixed : 0%

KRW fixed : 0%

Corp receives KRW 920 mio

Corp pays USD 1 mio

Corporate

Corp pays KRW at 5Y outright rate

Corp receives USD 1 mio

Now

5 years

Swap

Bank

Difference in FX rate

= swap points

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1.4.2 Fixed/Fixed Cross Currency Swap vs FX Swap

time

…… + -

time + -

……

FX Swaps = Near leg + Far leg

Cross Currency Swaps = S (FX swaps) assuming same frequency payment

Borrow in KRW interest rate

Lend in USD interest rate

= e.g. borrow KRW & lend USD

Cross Currency Swaps = e.g. long USD bond & short KRW bond

Long USD bond

Short KRW bond

How to get indicative data on CRS or CCS rates ?

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2.1 How to get quotes on Cross Currency Swap ?

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2.2.1 How to understand Cross Currency Swap quote ?

KRW 2.025%

semi-annually

USD 6 month

Libor flat

Swap

Desk Corporate

Corporate pays KRW fixed

KRW 1.425%

semi-annually

Swap

Desk Corporate

Corporate receives KRW fixed

USD 6 month

Libor flat

Ignoring the exchange of principals for simplicity

For 5Y CRS

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2.2.2 How to understand Currency Basis Swap quote ?


USD

6 month Libor flat

Swap

Bank Corporate

SGD 6M SOR

- 9 bp

Swap

Bank Corporate

Corporate receives SGD 6M SOR

USD

6 month Libor flat

Corporate pays SGD 6M Swap Offer Rates

SGD 6M SOR

+1 bp

For 1Y CBS,

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2.2.3 Understand Currency Basis Swaps from CRS & IRS

CRS Corporate Swap

Bank Market

IRS

SGD Fixed CRStenor

USD

6 month Libor flat

SGD Fixed IRStenor

SGD 6 month

SOR flat

SGD 6 month SOR +CBS USD

6 month Libor

flat

Market

Currency

Basis

Swap

Assume the same notional amount for all structures, in yield’s perspective :

Example, Fixed rate of CRStenor = Fixed rate of IRStenor + CBStenor

( CBS : Currency Basis Spread )

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2.2.4 Understand Currency Basis Swap from CRS and IRS

Assume the same notional amount for all structures, in yield’s perspective :

Fixed rate of CRS1Y = Fixed rate of IRS1Y + CBS1Y where CBS : Currency Basis Spread

0.519% = 0.508% + (1.1/100)%

IRS CBS

in bp

CRS

Prices are presented from the

Broker’s Swap Desk perspective,

that is, ask followed by bid

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2.2.5 Bird-eye View on Basis Spread & Currency Basis Spread

Term

Yield(t0) %

Tenor

Term

Tenor

Yield(t0) %

CBS(t0)

SGD fixed / SGD 6M SOR IRS Curve

SGD fixed / USD floating CRS Curve

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2.2.6 Usefulness of CBS : To construct the full FX outright Term Structure

For the shorter term of the FX outright term structure (till 1 year) , we may use spot FX and swap points to construct it. For the longer term of the FX outright term structure (more than 1 year) , we will use CBS spreads and other relevant information to construct it.

USD/KRW curves

Term

swap points

USD/KRW outrights curve

1 year

USD/KRW CBS spread curve

30 years 0

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2.2.7 Usefulness of CBS : To construct the full FX outright Term Structure

USD/KRW curves

Term

swap points


1 year


10 years 0

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2.2.8 Construct the full FX outright Term Structure

CBS spread term structure

USD’s discount factors

KRW’s discount factors

Spot USD/KRW

long term

USD/KRW

swap point

+

Spot

USD/KRW

long term

USD/KRW

outrights

short term USD/KRW

swap point

How to price a new CRS/CCS deal ?

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3.1 Cross Currency Swap Model

The model provides two way for valuating a Cross Currency Swap. CRS or CCS.

1. Spot : CBS adjustment are not applied (using 2 or more zero-coupon curves)

i. Discount all expected cashflows using their own zero-coupon curves

(e.g. USD, KRW)

ii. Convert the second currency to the first currency using FX spot rate.

2. FX Curve : CBS adjustment are applied (using only 1 zero-coupon curve)

< Financial Market preferred method and is adopted by Thomson Reuters

in the design of Currency Swap Pricer >

For example, CBS quotes are applied for first leg :

i. Convert all expected cashflows of first leg into the currency of the

second using all the relevant FX outrights (that is, adjusted by CBS).

ii. Discount all cashflows (include the converted ones) using the zero coupon

curve of the second leg.

Note

CBS spread adjustment : Currency Basis Swap spread adjustment

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3.1.1 Cross Currency Swap Pricing Methodology

CBS quotes are not applied CBS quotes are applied

A few Zero Curves

will be used for

discounting purpose

Pricing of Cross Currency Swap

Only 1 Zero Curves will be used for

discounting purpose.

(first leg’s or second leg’s)

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3.1.2 Currency Swap Pricing with 2 curves & 1 FX conversion

time

1. Get forecasted future USD cashflows (floating rate) from forward curve implied out

from current US zero coupon rates. Present value the USD cashflows.

……

time

2. Guess a reasonable KRW Fixed rate. Generate the KRW cashflows. Present value

the KRW cashflows.

…… + -

+ -

NPVUSD

via

Spot USD/KRW

NPVKRW

NPVUSD

3. Check the total present value from two cashflows but in only 1 currency,

if the value is not equal to zero, go back to step 2.

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3.2.1 Currency Swap Pricing Methodology

CBS quotes are not applied CBS quotes are applied

2 or 3 Zero Curves

will be used for

discounting purpose

Only 1 Zero Curves will be used for

discounting purpose

<Thomson Reuters’ approach>

(first leg’s or second leg’s)

Pricing of Cross Currency Swap

(tenor that is not standard,

example, 25m, 25 months)

Calculate CBS quotes from

Market Currency Swaps Quotes

Market Interest Rate Swaps Quotes

(standard tenors)

Market CBS quotes

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3.2.2 Currency Swap Pricing with 1 zero coupon curve

time

1. Get forecasted future USD cashflows (floating rate) from forward curve implied out

from current US zero coupon rates. Present value the USD cashflows.

……

time

2. Guess a reasonable KRW Fixed rate. Generate the KRW cashflows.

Convert each with its relevant FX outrights. Present value the USD cashflows.

……

+

-

+ -

NPVUSD

3. Check the total present value of the new set of cashflows, if the value is not equal

to zero, go back to step 2.

CBS spread translated to relevant FX outrights

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USD/KRW curves

Term

For the shorter term of the FX outright term structure (till 1 year) , we may use spot FX and swap points to construct it. For the longer term of the FX outright term structure (more than 1 year) , we will use CBS spreads and other relevant information to construct it.

swap points


1 year


30 years

0

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CBS spread term structure

USD’s discount factors

KRW’s discount factors

Spot USD/KRW

long term

USD/KRW

swap point

+

Spot

USD/KRW

long term

USD/KRW

outrights

short term USD/KRW

swap point

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3.2.5 Summary : Cross Currency Swap Pricing Methodology

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3.3 Locate “Currency Swap” calculator and understand the calculation

Received Leg

USD 3M Libor flat

Paid Leg

SGD Fixed rate 0.5971%

semi-annually

Swap

Bank Corporate

For 5Y CRS,

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3.4.1 Target Markets for Cross Currency Swaps, CRS or CCS

There are 4 clear target markets :

1. Investors who wish to purchase foreign assets but seek to eliminate foreign

currency exposure (The search for higher yield)

2. Debt issuers who can achieve more favourable rates by issuing debt in foreign

currency (The search for lower cost of capital)

3. Liability managers seeking to create synthetic foreign currency liabilities.

( Example : Currency loss on the assets will be offseted by

a corresponding Currency gain on the Cross Currency Swap)

4. Convert from float to fixed or vice versa in Structured Notes

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3.4.2 Create Synthetic USD floating rate notes

A US Fund Manager is seeking to purchase 3 year USD assets with a minimum credit

rating of AA and a yield in excess of USD 6M Libor+12bp. However, there may be no

such asset exist in reasonable volume at this time.

To create this asset synthetically, the Fund Manager may :

US Fund

Manager

GBP FRN

Issuer

GBP 6M Libor+ 18bp

Swap

Bank

GBP 6M Libor + 18bp

USD 6M Libor + ???

> USD 6M Libor + 12bp

Investor buys Bond -GBP 10 million

Currency Swap +GBP 10 million

-USD 20 million

Initial cashflows

Bond Redeems to

Investor

+GBP 10 million

Currency Swap -GBP 10 million

+USD 20 million

At Maturity cashflows

(irrespective of the prevailing exchange rate)

Note : US Fund Manager bears the full credit risk of the underlying bond and should the bond

default, the investor is still obliged to make all remaining payments under the Swap or reverse

the swap at the book value at that time.

If there is a GBP FRN that offers 6M Libor + 18bp, Fund Manager will take it.

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3.4.3 Day Count Basis (per year) for onshore & offshore

Domestic for onshore bank’s computation.

(for example, citibank in USA)

Euro for offshore bank’s computation.

(for example, citibank in Singapore)

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For 3 years, Corporate will

pay GBP 6 month Libor + 18bp &

receive USD 6 month Libor + 22.05bp

that is, better than expected

US Fund

Manager

GBP 6M Libor + 18bp

USD 6M Libor + 22.05bp

> USD 6M Libor + 12bp

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US Fund

Manager Swap

Bank Market

IRS

GBP 6 month Libor

+ 18bp

USD 6 month Libor

+ 22.05bp

USD Fixed

USD 6 month Libor

GBP 6 month Libor USD Fixed

CRS

Market

Currency Basis Swap



pay GBP 6 month Libor + 18bp &

receive USD 6 month Libor + 22.05bp

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3.5.2 Create Synthetic NZD debt or loan

A New Zealand company is looking to raise NZD 100 million by issuing 9 years bonds.

In the New Zealand domestic market, it would issue at a yield of

NZD 6M bank bill + 300bp. Alternatively it can issue in Australia where there is a

shortage of quality bonds, at a yield of 8%.

To create this liability synthetically, the New Zealand company may :

NZ

Company

AUD straight bond

Investors

Swap

Bank

NZD 6M bankbill+??? bp <

NZD 6M bankbill+300bp

AUD 8%

Company issues Bond +AUD 80.2 million

Currency Swap -AUD 80.2 million

+NZD 100 million

Initial cashflows

Bond Redeems to

Investor

-AUD 80.2 million

Currency Swap +AUD 80.2 million

-NZD 100 million

At Maturity cashflows

(irrespective of the prevailing exchange rate)

AUD 8%

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pay NZD 6 bankbill + 433.26bp &

receive AUD 8% semi-annually.

this is worse, so forget about AUD arrangement

NZ

Company

NZD 6M bankbill + 433.26bp >

NZD 6M bankbill + 300bp

AUD 8%

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CRS

NZ

Company Swap

Bank Market

Market

IRS

NZD 6 month Bankbill

+ 433.26 bp

AUD 8%

semi-annual

AUD 6 mth Bankbill

AUD Fixed

NZD 6 month Bankbill

+ CBS AUD

6 mth Bankbill

Currency

Basis

Swap



pay NZD 6 month Bankbill + 433.26bp &

receive AUD 8% semi-annually.

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3.6.2 Motivation : Reduce the Volatility of Earnings

A US company uses USD as its base currency but has Assets denominated in INR.

The Board of Directors are concerned that any fluctuations in the spot FX will lead to an

increase in the volatility of earnings.

In total, there are INR 40 billion Asset with no corresponding INR liabilities.

The majority of company liabilities are denominated in USD.

The currency exchange rate is 1 USD = 54 INR.

Liabilities

Balance Sheet before Cross Currency Swap

Equity

Present Value in USD

Asset

Market Value

= INR 40 bn

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The Company has considered raising INR debt in the India market and repaying USD

debt as a way to hedge this exposure and would need to pay INR 1Y Mifor – ??? bp

Multi-national

company

INR 1Y Mifor + ??? bp

USD 1Y Libor

USD 1Y Libor

Swap

Bank

Banks

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There is no new requirement to generate cash and so the company elects not to

exchange principal at the start of the deal, so there are no initial cashflows.

In effect, the company has transferred some of its USD liabilities into INR liabilities to

offset the INR assets it owns and thereby reduce its currency exposure.

Liabilities

Balance Sheet after Cross Currency Swap

Equity

Present Value in INR

Asset

Market Value

= INR 40 bn

From this point on, any Currency loss on the assets will be offseted by a corresponding

Currency gain on the Cross Currency Swap.

Thus, the Cross Currency Swap has been used as an effective FX hedge much like the

use of a FX swap contract.

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3.6.5 Hedge FX risk


pay INR 1 year Mifor – 486.37bp &

receive USD 1 year Libor flat

Multi-national

company

INR 1Y Mifor – 486.37bp

USD 1Y Libor flat

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3.6.6 Motivation : hedge FX risk

Multi-National

Company Swap

Bank Market

IRS

INR 1 year Mifor

- 442.25bp

USD 1 year Libor flat

USD Fixed

USD 1 year Libor flat

INR 1 year Mifor USD Fixed CRS

Market

Currency Basis Swap



pay INR 1 year Mifor – 442.25bp &

receive USD 1 year Libor flat

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Reverse engineering

on Lehman Brothers’ Minibond

series 9 & 10

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3.7.2 Reverse Engineering on Minibond series 9 & 10

Credit Protection on Aviva PLC’s bonds

Credit Portfolio

CDS premiums

Single Tranche (e.g. “AAA”)

Cash comes

from Noteholders

( some are

Vulnerable

Investors)

No Default scenario

Series 9 : SGD 4.3% pa for 4.75 years

payable on 14 Feb, May, Aug, Nov

Investors

Funded credit link notes

possibly, US Treasury Bonds

ELIGIBLE COLLATERAL

FX converted

cash to

purchase

Coupon

Interests

Credit Event Loss Payments

(Par)

Credit Portfolio contains mainly six 5Y CDS (physical settlement).

Credit Protection on PRC of China’s bonds

Credit Protection on HSBC bank’s bonds

Credit Protection on Malaysia’s bonds

Credit Protection on Prudential’s bonds

Credit Protection on Singtel’s bonds

Coupon Interests

after CRS

+ CDS premium

… …

Funded

… …

Default scenario Recovery Values

Protection Buyers

IRS may be utilised to convert from fixed to floating and vice versa in series 10 (USD)

Currency Swap may be utilised to convert multi-period cashflow, from 1 currency to another in series 9.

Credit Events (should follow CR doc)

Failure to Pay,

Debt Restructuring,

for Sovereign for other entities

Repudiation/Moratorium Bankruptcy

SP/Moody

A+/A2

A/A1

AA/Aa1

A-/A3

A+/A2

A+/Aa2

INVESTMENT RISK & RISK FACTORS “… you could lose all or a substantial part of your investment in the Notes”

Minibond Limited is theSPC (with USD 1000 in capital)

Swap Counterparty (Lehman)

Swap Guarantor (Lehman)

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3.7.3 The Incomplete Journey

Sophisticated & “vulnerable investors”

waiting in vain for the delivery

The Titanic (Swap Counterparty/Guarantor)

called “Lehman Brothers”

“riskfree”

US Treasury Bond’s Yield

Aviva,

PRC of China,

HSBC bank,

Govt. of Malaysia,

Prudential,

Singtel’s

CDS premiums

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3.7.4 There are 2 Cross Currency Involved : First one is

Lehman

Brother Swap

Desk

CRS

USD Fixed 1.5%, semi

SGD Fixed rates, qtr


For 4Y9M years, the Lehman Brother will

pays USD fixed rates same as the 5Y USD government Treasury Notes

receive SGD fixed rates

5Y USD

Treasury Notes

USD Fixed 1.5%, semi

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3.7.5 The first Cross Currency Swap deal is

51


3.7.6 There are 2 Cross Currency Involved : Second one is

Lehman

Brother Swap

Desk

IRS

USD Fixed ???, qtr

SGD Fixed rates, qtr


For 4Y9M years, the Lehman Brother will

pays USD fixed rates = All 5Y CDS premium collected

receive SGD fixed rates = 4.3% - the SGD fixed rate calculated from the first CRS or CCS

All

5Y CDS premiums

USD Fixed ???, qtr

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3.7.7 The second Cross Currency Swap deal is

Mark-to-Model/Market

for a Cross Currency Swap

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4. Mark-to-Model/Market for an existing Cross Currency Swap deal

Company

Agree to pay KRW 0.28%

quarterly on an earlier

trade date 17 Jan 2012

(1 year ago)

USD 3M Libor flat

To unwind this position,

Company will get KRW 675400.48

Locking the Maturity Date

Locking the Agreed Fixed Rate

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5.1 Conclusion

1. Learn how to get indicative data on IRS or CCS rates, <SWAP/1>

2. Learn how to price a new IRS or CCS deal with the Swap Pricer model.

3. Learn how to Mark-to-Model(Market) an existing IRS or CCS deal.

- Key in (lock) the maturity date.

- Key in (lock) contracted swap rate in the “Fixed Rate” cell

- Mark-to-Model(Market) = Net Present Value (NPV)

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5.2 Where are CRS (CCS) in the Grand Scheme of Things ?

Yield(t)

%

Term

Investors hope to lend at higher rate. Debtors hope to borrow at lower rate.

Libor curve

6M Libor(t) + ASW

10Y IRS(t) +CMS

Benchmark curve

Zero-coupon curve

(constructed from US Treasury curve)

5Y Zero rate(t) + Z spread

20Y Bmk(t) + credit spread

Callable Bond Yield

3Y Bmk(t) +CMT

ASW: Asset Swap spread, CDS: Credit Default Swap spread, CMS: Constant Maturity Swap spread

CMT: Constant Maturity Treasury Swap spread, Z-spread: static spread, CBS: Currency Basis Swap spread

Convertible Bond Yield

Straight Bond Yield

CDS curve

CDS

Currency Swap curve (CRS)

CBS

Interest Rate Swap curve (IRS)

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Asset Swap (ASW : Asset Swap spread) : “Transformer”

Bond

Holder Swap

Desk

IRS

USD Fixed 5%

USD 6M Libor + ASW

Due to this arrangement,

Bond holder is not owning straight bond but a Floating Rate Notes which yields USD 6M Libor + ASW

Straight

Bond

USD Fixed coupon 5%

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Cross Currency Asset Swap : “Transformer”

Bond

Holder Swap

Desk

CRS

USD Fixed 5%

SGD 6M SOR + ASW

Due to this arrangement,

Bond holder is not owning USD straight bond but a SGD Floating Rate Notes

which yields SGD 6M SOR + ASW

Straight

Bond

USD Fixed coupon 5%

Documents

FI - Overview of Cross Currency Swaps via Swap Pricer