Swap Currency & Interest Rate. Currency & Interest Rate Swaps This chapter discusses currency and interest rate swaps, which are relatively new instruments

swapswap

Currency & Interest Rate

Currency & Interest Rate Swaps

This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk.

OutlineOutline

Types of SwapsTypes of Swaps Size of the Swap MarketSize of the Swap Market The Swap BankThe Swap Bank Interest Rate SwapsInterest Rate Swaps Currency SwapsCurrency Swaps

Outline (continued)Outline (continued)

Swap Market QuotationsSwap Market Quotations Variations of Basic Currency and Interest RVariations of Basic Currency and Interest R

ate Swapsate Swaps Risks of Interest Rate and Currency SwapsRisks of Interest Rate and Currency Swaps Swap Market EfficiencySwap Market Efficiency Concluding Points About SwapsConcluding Points About Swaps

DefinitionsDefinitions

In a swap, two In a swap, two counterpartiescounterparties agree to a co agree to a contractual arrangement wherein they agree to ntractual arrangement wherein they agree to exchange cash flows at periodic intervals.exchange cash flows at periodic intervals.

There are two types of interest rate swaps:There are two types of interest rate swaps:– Single currency interest rate swapSingle currency interest rate swap

““Plain vanilla” fixed-for-floating swaps are often just cPlain vanilla” fixed-for-floating swaps are often just called alled interest rate swapsinterest rate swaps..

– Cross-Currency interest rate swapCross-Currency interest rate swap This is often called a This is often called a currency swapcurrency swap; fixed for fixed ra; fixed for fixed ra

te debt service in two (or more) currencies.te debt service in two (or more) currencies.

Size of the Swap MarketSize of the Swap Market

In 2001 the notational principal of:In 2001 the notational principal of:Interest rate swaps was $58,897,000,000.Interest rate swaps was $58,897,000,000.Currency swaps was $3,942,000,000Currency swaps was $3,942,000,000

The most popular currencies are:The most popular currencies are:– U.S. dollarU.S. dollar– Japanese yenJapanese yen– EuroEuro– Swiss francSwiss franc– British pound sterlingBritish pound sterling

The Swap BankThe Swap Bank

A swap bank is a generic term to describe a A swap bank is a generic term to describe a financial institution that facilitates swaps financial institution that facilitates swaps between counterparties.between counterparties.

The swap bank can serve as either a broker The swap bank can serve as either a broker or a dealer.or a dealer.– As a broker, the swap bank matches counterparties but As a broker, the swap bank matches counterparties but

does not assume any of the risks of the swap.does not assume any of the risks of the swap.– As a dealer, the swap bank stands ready to accept As a dealer, the swap bank stands ready to accept

either side of a currency swap, and then later lay off either side of a currency swap, and then later lay off their risk, or match it with a counterparty. their risk, or match it with a counterparty.

An Example of an Interest Rate An Example of an Interest Rate SwapSwap

Consider this example of a “plain vanilla” intConsider this example of a “plain vanilla” interest rate swap.erest rate swap.

Bank A is a AAA-rated international bank locBank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,ated in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.000 to finance floating-rate Eurodollar loans.– Bank A is considering issuing 5-year fixed-rate EurodollBank A is considering issuing 5-year fixed-rate Eurodoll

ar bonds at 10 percent.ar bonds at 10 percent.– It would make more sense for the bank to issue floating-It would make more sense for the bank to issue floating-

rate notes at LIBOR to finance floating-rate Eurodollar lorate notes at LIBOR to finance floating-rate Eurodollar loans.ans.


Firm B is a BBB-rated U.S. company. It Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment needs $10,000,000 to finance an investment with a five-year economic life.with a five-year economic life.– Firm B is considering issuing 5-year fixed-rate Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.Eurodollar bonds at 11.75 percent.– Alternatively, firm B can raise the money by issuing 5-Alternatively, firm B can raise the money by issuing 5-

year floating-rate notes at LIBOR + ½ percent.year floating-rate notes at LIBOR + ½ percent.– Firm B would prefer to borrow at a fixed rate.Firm B would prefer to borrow at a fixed rate.


The borrowing opportunities of the two firms The borrowing opportunities of the two firms are:are:

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR


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 COMPANY B BANK A



Swap

Bank

LIBOR – 1/8%

10 3/8%

Bank

A


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.

10%

½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years.

Swap

Bank

LIBOR – 1/8%

10 3/8%

Bank

A

COMPANY B BANK A




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. COMPANY B BANK A



Company

B

Swap

Bank10 ½%

LIBOR – ¼%


An Example of an An Example of an Interest Rate Swap:Interest Rate Swap:

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.

COMPANY B BANK A



LIBOR + ½%

½ % of $10,000,000 = $50,000 that’s quite a

cost savings per year for 5 years.

Swap

Bank

Company

B

10 ½%

LIBOR – ¼%


The swap bank makes money too.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

10 ½ - 10 3/8 = 1/8

¼

Swap

Bank

Company

B

10 ½%

LIBOR – ¼%LIBOR – 1/8%

10 3/8%

Bank

A

COMPANY B BANK A




The swap bank makes ¼%

Swap

Bank

Company

B

10 ½%

LIBOR – ¼%LIBOR – 1/8%

10 3/8%

Bank

A

B saves ½%A saves ½% COMPANY B BANK A



An Example of a Currency SwapAn Example of a Currency Swap

Suppose a U.S. MNC wants to finance a Suppose a U.S. MNC wants to finance a £10,000,000 £10,000,000 expansion of a British plant.expansion of a British plant.

They could borrow dollars in the U.S. where they They could borrow dollars in the U.S. where they are well known and exchange for dollars for are well known and exchange for dollars for pounds.pounds.– This will give them exchange rate risk: financing a This will give them exchange rate risk: financing a

sterling project with dollars.sterling project with dollars. They could borrow pounds in the international They could borrow pounds in the international

bond market, but pay a premium since they are bond market, but pay a premium since they are not as well known abroad.not as well known abroad.


If they can find a British MNC with a mirror-If they can find a British MNC with a mirror-image financing need they may both benefit image financing need they may both benefit from a swap.from a swap.

If the spot exchange rate is If the spot exchange rate is SS00($/($/£) = £) =

$1.60/£, the U.S. firm needs to find a British $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in firm wanting to finance dollar borrowing in the amount of $16,000,000.the amount of $16,000,000.


Consider two firms A and B: firm A is a U.S.Consider two firms A and B: firm A is a U.S.––based multinatibased multinational and firm B is a U.K.–based multinational.onal and firm B is a U.K.–based multinational.

Both firms wish to finance a project in each other’s country of Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in tthe same size. Their borrowing opportunities are given in the table below.he table below.

$ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%


$9.4%

Firm

B

$8% £12%

Swap

Bank

Firm

A

£11%

$8%

£12%

$ £


Company B 10.0% 12.0%


$8% £12%Firm

B

Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%

A saves £.6%

$ £


Company B 10.0% 12.0%

A’s net position is to borrow at £11%


$8% Firm

B

Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%

B’s net position is to borrow at $9.4%

B saves $.6% $ £


Company B 10.0% 12.0%


$8% £12%Firm

B

The swap bank makes money too:

At S0($/£) = $1.60/£, that is a gain of $124,000 per

year for 5 years.

Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%

1.4% of $16 million financed with 1% of £10 million per year

for 5 years.

The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).

$ £


Company B 10.0% 12.0%

The QSDThe QSD

The Quality Spread Difference represents the The Quality Spread Difference represents the potential gains from the swap that can be shared potential gains from the swap that can be shared between the counterparties and the swap bank.between the counterparties and the swap bank.

There is no reason to presume that the gains will There is no reason to presume that the gains will be shared equally.be shared equally.

In the above example, company B is less credit-In the above example, company B is less credit-worthy than bank A, so they probably would have worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate gotten less of the QSD, in order to compensate the swap bank for the default risk.the swap bank for the default risk.

Comparative Advantage Comparative Advantage as the Basis for Swapsas the Basis for Swaps

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.

$ £


Company B 10.0% 12.0%

AA is the more credit-worthy of the two firms. is the more credit-worthy of the two firms.

A pays 2% less to borrow in dollars than B

A pays .4% less to borrow in pounds than B:


B B has a comparative advantage in borrowing in has a comparative advantage in borrowing in ££..

B pays 2% more to borrow in dollars than A $ £


Company B 10.0% 12.0%

B pays only .4% more to borrow in pounds than A:


AA has a has a comparative advantagecomparative advantage in borrowing in borrowing in dollars.in dollars.

B B has a comparative advantage in borrowing ihas a comparative advantage in borrowing in pounds.n pounds.

If they borrow according to their comparative aIf they borrow according to their comparative advantage and then swap, there will be gains dvantage and then swap, there will be gains for both parties.for both parties.

Swap Market QuotationsSwap Market Quotations

Swap banks will tailor the terms of interest rate anSwap banks will tailor the terms of interest rate and currency swaps to customers’ needsd currency swaps to customers’ needs

They also make a market in “plain vanilla” swaps aThey also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks nd provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask sprare dealers for these swaps, there is a bid-ask spread.ead.

For example, 6.60 For example, 6.60 —— 6.85 means the swap bank 6.85 means the swap bank will pay fixed-rate payments at 6.60% against recewill pay fixed-rate payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate paymiving dollar LIBOR or it will receive fixed-rate payments at 6.85% against receiving dollar LIBOR.ents at 6.85% against receiving dollar LIBOR.

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

– fixed for fixed fixed for fixed – fixed for floatingfixed for floating– floating for floatingfloating for floating– amortizingamortizing

For a swap to be possible, a QSD must exisFor a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.t. Beyond that, creativity is the only limit.

Risks of Interest Rate Risks of Interest Rate and Currency Swapsand Currency Swaps

Interest Rate RiskInterest Rate Risk– Interest rates might move against the swap bank after it Interest rates might move against the swap bank after it

has only gotten half of a swap on the books, or if it has ahas only gotten half of a swap on the books, or if it has an unhedged position.n unhedged position.

Basis RiskBasis Risk– If the floating rates of the two counterparties are not pegIf the floating rates of the two counterparties are not peg

ged to the same index.ged to the same index.

Exchange rate RiskExchange rate Risk– In the example of a currency swap given earlier, the swaIn the example of a currency swap given earlier, the swa

p bank would be worse off if the pound appreciated. p bank would be worse off if the pound appreciated.

Risks of Interest Rate Risks of Interest Rate and Currency Swaps (continued)and Currency Swaps (continued)

Credit RiskCredit Risk– This is the major risk faced by a swap dealer—the risk tThis is the major risk faced by a swap dealer—the risk t

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

Mismatch RiskMismatch Risk– It’s hard to find a counterparty that wants to borrow the rIt’s hard to find a counterparty that wants to borrow the r

ight amount of money for the right amount of time.ight amount of money for the right amount of time.

Sovereign RiskSovereign Risk– The risk that a country will impose exchange rate restrictThe risk that a country will impose exchange rate restrict

ions that will interfere with performance on the swap.ions that will interfere with performance on the swap.

Pricing a SwapPricing a Swap

A swap is a derivative security so it can be pA swap is a derivative security so it can be priced in terms of the underlying assets:riced in terms of the underlying assets:

How to:How to:– Plain vanilla fixed for floating swap gets valued jPlain vanilla fixed for floating swap gets valued j

ust like a bond.ust like a bond.– Currency swap gets valued just like a nest of cuCurrency swap gets valued just like a nest of cu

rrency futures.rrency futures.

Swap Market EfficiencySwap Market Efficiency

Swaps offer Swaps offer market completenessmarket completeness and that has and that has accounted for their existence and growth.accounted for their existence and growth.

Swaps assist in tailoring financing to the type Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all desired by a particular borrower. Since not all types of debt instruments are available to all types types of debt instruments are available to all types of borrowers, both counterparties can benefit (as of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is well as the swap dealer) through financing that is more suitable for their asset maturity structures.more suitable for their asset maturity structures.

Concluding RemarksConcluding Remarks

The growth of the swap market has been astThe growth of the swap market has been astounding.ounding.

Swaps are off-the-books transactions.Swaps are off-the-books transactions. Swaps have become an important source of Swaps have become an important source of

revenue and risk for banksrevenue and risk for banks

Managing Financial RiskManaging Financial Risk

Understand the basic difference between Understand the basic difference between hedging and speculatinghedging and speculating

Discern between the types of hedging Discern between the types of hedging strategies using futures, options, swaps, and strategies using futures, options, swaps, and products such as interest rate ceiling, floor, products such as interest rate ceiling, floor, and collarsand collars

Develop appropriate interest rate hedging Develop appropriate interest rate hedging strategiesstrategies

Financial RiskFinancial Risk

Changes inChanges in– interest ratesinterest rates– foreign exchange ratesforeign exchange rates– commodities pricescommodities prices

Risk ProfileRisk Profile

Attitude towards risk for each potential expoAttitude towards risk for each potential exposure.sure.

Risk-return tradeoff.Risk-return tradeoff. Basis for financial risk management.Basis for financial risk management.

Objectives of Financial Risk Objectives of Financial Risk ManagementManagement

Determine Risk ProfileDetermine Risk Profile– Value at Risk(VAR)Value at Risk(VAR)

Set Basic GoalsSet Basic Goals Identify and Measure the Level of Risk ExpoIdentify and Measure the Level of Risk Expo

suresure Manage ExposureManage Exposure Monitor ExposureMonitor Exposure

Hedging vs. SpeculatingHedging vs. Speculating

A hedger has a cash position or an anticipatA hedger has a cash position or an anticipated cash position that he or she is trying to pred cash position that he or she is trying to protect from adverse interest rate movementsotect from adverse interest rate movements

A speculator has no operating cash flow posA speculator has no operating cash flow position to protect and is trying to profit solely frition to protect and is trying to profit solely from interest rate movementsom interest rate movements

Some Important TermsSome Important Terms

HedgerHedger SpeculatorSpeculator ArbitrageArbitrage Perfect vs imperfect hedgePerfect vs imperfect hedge Pure vs anticipatory hedgePure vs anticipatory hedge Partial and cross hedgePartial and cross hedge Long (buy) and short (sell) hedgeLong (buy) and short (sell) hedge Mark to marketMark to market

HedgerHedger Entity that uses financial instruments to reduce the price risksEntity that uses financial instruments to reduce the price risks

associated with his basic business activities. By assuming a associated with his basic business activities. By assuming a

position in the futures market that is equal and opposite to theposition in the futures market that is equal and opposite to the

position in the cash market, the hedger established a situationposition in the cash market, the hedger established a situation

where losses in the cash market are offset by gains in the where losses in the cash market are offset by gains in the

futures market and vice versa.futures market and vice versa.

SpeculatorSpeculator

An entity who takes a position in the finaAn entity who takes a position in the financial market that is notncial market that is not

offset by an opposite position in a basic loffset by an opposite position in a basic line of business. ine of business.

A speculator “bets” on the direction of thA speculator “bets” on the direction of the market and is willing to assume riske market and is willing to assume risk

ArbitrageArbitrage

Process by which buying in one market aProcess by which buying in one market and selling in anothernd selling in another

Leads to a riskless profit. Arbitragers do Leads to a riskless profit. Arbitragers do not assume risk, but profit from market inot assume risk, but profit from market inefficienciesnefficiencies

Perfect vs Imperfect HedgePerfect vs Imperfect Hedge

A A perfect hedge perfect hedge is one where the individis one where the individual is able to eliminate all risk of price fluual is able to eliminate all risk of price fluctuations.ctuations.

Pure vs Anticipatory HedgePure vs Anticipatory Hedge A A pure hedge pure hedge is one where the individual assumes a position in is one where the individual assumes a position in

the futures market equal and opposite to the current positionthe futures market equal and opposite to the current position

in the cash market (such as hedging a riding the yield curve in the cash market (such as hedging a riding the yield curve

position).position).

An An anticipatory hedge anticipatory hedge is taking a position that is a temporaryis taking a position that is a temporary

substitute for an anticipated position in the cash market.substitute for an anticipated position in the cash market.

Partial and Cross HedgePartial and Cross Hedge

A A partial hedge partial hedge is where the person takes is where the person takes a position in the futures market that is sa position in the futures market that is smaller than the cash position.maller than the cash position.

A A cross hedge cross hedge is where the manager useis where the manager uses a different hedgings a different hedging

instrument (futures instrument) than the instrument (futures instrument) than the hedged cash instrument.hedged cash instrument.

Long (buy) and Short (sell) HedgeLong (buy) and Short (sell) Hedge

A A long hedge long hedge is where the firm BUYS a futures contract.is where the firm BUYS a futures contract.

A A short hedge short hedge is where the firm SELLS a futures contract.is where the firm SELLS a futures contract.

A long hedge is appropriate when the firm will buy an asset inA long hedge is appropriate when the firm will buy an asset in

the future or sell a liability prior to maturity.the future or sell a liability prior to maturity.

A short hedge is appropriate when the firm issues a liabilityA short hedge is appropriate when the firm issues a liability

in the future or sells a current cash position in the future.in the future or sells a current cash position in the future.

Mark to MarketMark to Market

Everyday the gain or loss on a futures poEveryday the gain or loss on a futures position causes yoursition causes your

margin account to be adjusted, gains or margin account to be adjusted, gains or credited to your account and losses or dcredited to your account and losses or debitedebited

Buy vs. Sell HedgeBuy vs. Sell Hedge

Type of hedge should depend on the nature Type of hedge should depend on the nature of the cash flow position being hedged, not of the cash flow position being hedged, not on the anticipated direction of interest rates.on the anticipated direction of interest rates.

Buy Hedge: A future investment or retiring a Buy Hedge: A future investment or retiring a liability prior to maturityliability prior to maturity

Sell Hedge: Issue a liability in the future or Sell Hedge: Issue a liability in the future or sell an investment prior to its maturitysell an investment prior to its maturity

Why Hedges Are Not PerfectWhy Hedges Are Not Perfect

Futures contract in general have only four eFutures contract in general have only four expiration dates per year. (Note T-bills: Mar, xpiration dates per year. (Note T-bills: Mar, June, Sept, and Dec.June, Sept, and Dec.

Correlation coefficient of spot rates and futurCorrelation coefficient of spot rates and futures rates is less than 1.0es rates is less than 1.0

Other Hedging InstrumentsOther Hedging Instruments

Interest rate capsInterest rate caps– Purchaser pays a premium and receives cash payments from the Purchaser pays a premium and receives cash payments from the

cap seller when the reference rate exceeds strike rate.cap seller when the reference rate exceeds strike rate.

Interest rate floorsInterest rate floors– Purchaser pays a premium for the rate floor contract, receives cash Purchaser pays a premium for the rate floor contract, receives cash

payment when reference rate falls below strike rate.payment when reference rate falls below strike rate.

Interest rate collarsInterest rate collars– Purchase a rate cap and sell or issue a rate floor. Pay a premium Purchase a rate cap and sell or issue a rate floor. Pay a premium

for the cap and receive a premium for the floor.for the cap and receive a premium for the floor.

Types of Foreign Exchange Types of Foreign Exchange ExposureExposure

Transaction ExposureTransaction Exposure Translation ExposureTranslation Exposure Economic ExposureEconomic Exposure

Foreign Exchange MarketsForeign Exchange Markets

Spot Market and the Spot Foreign Exchange Spot Market and the Spot Foreign Exchange RateRate

Forward Market and the Forward Exchange Forward Market and the Forward Exchange RateRate

Forward Exchange Rate and Interest Rate PForward Exchange Rate and Interest Rate Parityarity

Type of FX ContractsType of FX Contracts

ForwardsForwards FuturesFutures Currency SwapsCurrency Swaps OptionsOptions

Documents

Swap Currency & Interest Rate. Currency & Interest Rate Swaps This chapter discusses currency and interest rate swaps, which are relatively new instruments