Swaps

• Add a swap to a loan to change loan’s type• Plain vanilla interest rate swap – domestic

currency denominated but involving different loan structures, fixed vs. floating rate loans

• Plain deal foreign currency swap – same loan structure, fixed interest rate, but different currencies.

Interest Rate Swap

• Swap interpretation: investing in one type and financing in another type

• Types = fixed versus floating rate

• Coy. B, due to higher credit rating, has an absolute advantage in both types

Plain Vanilla Interest Rate Swap

• Coy. B has comparative advantage in fixed rate, interest advantage is greater

• Coy. A has comparative advantage in floating rate!!, interest disadvantage is less

• Coys. A and B, each has a comparative advantage in the type of loan each does not desire

• Preconditions of a viable swap

Interest Rate Swap

• Page 2 depicts a specific swap

• Other swaps are possible: triangular region specified by the 3 inequalities on page 3

• On border of triangle, one party does not gain; on vertex, two parties do not gain

• Gain = 65 basis points for all swaps

FX Swap

• Canuck Avions de Ligne, Ltée Case• Comparative advantage requirement for a

viable swap is satisfied• CAL has comparative advantage in real,

Garota has comparative advantage in C$• But CAL wants C$, Garota wants reais • Add FX swap to financing in one currency;

result: financing in the other currency

FX Swap

• Interpretation: A portfolio (5-pack) of forward contracts with different maturities

• CAL buys real forward to hedge real loan• Garota buys C$ forward to hedge C$ loan• Implied forward rate common to all 5

maturities is BR7.824/C$ vs. spot rate of BR7.366/C$, qualitatively consistent with IRP.

FX Swap Effects

• Garota obtains real financing at its prespecified required rate of 15%, this built into swap cash flow calculations

• CAL obtains C$ financing at 9.61%, calculated using the Excel’s IRR function

• CAL reduces its C$ financing cost by 89 basis points

Viñas de Valdivia, SA

• Determine the reference currency (Chilean peso) cost of financing in another currency (U$) via ex-post Uncovered Interest Parity

• Technique applies only to pure discount loan arrangement

• UIP: (1+ KU$) = (1+10%)(1+a) where KU$ is the Chilean peso cost of U$ financing and a is the annual appreciation of U$

Viñas de Valdivia, SA

• Construct sensitivity analysis graph: gauge sensitivity of Chilean peso cost to a

• Breakeven value of a is 36.36%, where the peso costs are equalized

• At projected a, peso debt is cheaper

• Better to borrow at 50% than at 10%!!!!

• 10% in U$’s is 65% in Chilean pesos.

Bling-Bling Corporation

• Must use IRR function, cannot use ex-post Uncovered Interest Parity, since loan not pure discount arrangement

• Complication: issue costs

• Issue cost % applies to the gross financing

• Gross-up the net financing

Bling-Bling Corporation

• Yen cash flows must be forward hedged

• FX loan: sell loan proceeds at Bid, buy debt service at Ask

• Criterion: Minimize cost of financing in the reference currency (U$)

• Technique: determine vector of U$ cash flows, then apply IRR function

Hedging FX financing cash flows

• Canuck Avions case: one swap.• Bling-Bling case: five forward contracts• Bling-Bling must buy JY288,659,794

forward for years 1, 2, 3, 4, 5 and JY7,216,494,880 for year 5.

• Valid comparison of reference currency vs. FX financing requires that the latter be fully hedged

Principal Repayment Arrangements

• 0. Zero-Coupon-type: only 1 debt service date.• 1. Bond-type: pay only interest; at maturity repay entire

principal.• 2. Mortgage-type: fully amortized with equal annual debt

service (blend of interest and principal repayment).• 3. Type-3: Principal repaid in equal annual installments;

debt service declines during loan life. • Ranked from fastest to slowest pace of principal

repayment: 3, 2, 1, 0. The higher the number, the faster the pace of principal repayment.

Equal annual repayment of principal (type 3 loan)

• Borrow $1 at 10% over two years.

• Principal repayment = 0.5 per year.

• Interest payments: year1 = $1 x 10% = .1; year2 = $.5 x 10% = .05

• Debt service: year1 = .5 + .1 = .6; year2 = .5 + .05 = .55

• Cash flows: 1; -.6; -.55. IRR = 10%

Tabular format for type 3 loan

Year Principal@Start

Principal Repay.

Interest Payment

Debt Service

1 1 .5 .1 = 1(10%)

.6

2 .5 .5 .05 = .5(10%

)

.55

Pure discount or zero coupon loan

• Net = $100, F = 5%, interest rate = 10%, maturity = 3 years, Gross = $100 / (1-.05) = $105.26

• Debt service occurs at only one point in time, end of year 3 (loan’s maturity)

• Debt service = 105.26(1.1)^3 =140.10• Initial financing reflects Net • Debt service reflects Gross• Cash flows: 100, 0, 0, -140.10• All-in Cost = 11.9%

Effect of up-front fee on pace of principal repayment to minimize all-in cost

• Borrow $1 over 2 years: 10% interest rate, 5% up-front fee

• Grossed-up principal = 1.05263 = 1/(1-.05)

• Mortgage-type loan: 1; -0.6065; -0.6065 implies cost = 13.9%

• Pure-discount bond: 1; 0 ; -1.27368 implies cost = 12.86%

• Choose slow pace of principal repayment to amortize up-front loan processing fee over longer effective time horizon (or bond duration).

• The faster the pace of principal repayment (other things equal), the higher the all-in cost.

No interest loan! (but loan processing fee charged)

• F=5%: need Net=$100, Gross= $105.26• If pay @ end year 1: Cost = 5.26% since

cash flows are 100, -105.26• If pay @ end year 2: Cost = 2.6% since

cash flows are 100, 0, -105.26• Moral of the story: If incur up-front loan

processing fee, choose longest maturity possible.

Effects of loan processing fee (F) and FX-denomination

Situation Pace of Principal Repayment to Reduce Financing Cost

Incur F; no FX Slow

No F; appreciating FX Fast

No F; depreciating FX Slow

Financing in FX and incur up-front processing fee

• If FX is projected to depreciate or exhibits a forward discount, repay principal slowly, other things equal. Unambiguous: Go slooow bro!

• If FX is projected to appreciate or exhibits a forward premium, the two loan facets have contradictory effects. Ambiguous: Dunno bro!

• Two loan facets: financing in an FX and incur processing fee up-front.

Covered/Uncovered Interest Parity: Implications

• High interest rate currency trades at a forward discount and will depreciate.

• Low interest rate currency trades at a forward premium and will appreciate.

• The two effects work at cross purposes: one raises, the other lowers the cost of financing in the reference currency.

• Implication: Apply Excel’s IRR function!

Dubious Rules of Thumb

• Definitions: soft currency, likely to depreciate; hard currency, likely to appreciate.

• Always finance in a soft currency. Problem: such a currency exhibits high interest rate.

• Always finance in a low interest currency. Problem: such a currency will likely appreciate. Low interest currencies are hard.

Attaching FX Derivatives

• An arbitrage play: firm seeking financing must be able to sell the FX derivative at a higher price than that at which it buys the same FX derivative

• Financial institutions must face regulatory restrictions which preclude them from direct purchase of the FX derivative

• Dual currency or currency option bonds circumvent restrictions