Copyright © 2012 by the McGraw-Hill Companies, Inc. All rights reserved. Interest Rate & Currency Swaps Chapter Fourteen

Chapter Outline  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  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? 14-2

Definitions  In a swap, two counterparties agree to a contractual arrangement wherein they will exchange cash flows at periodic intervals.  There are two types of interest rate swaps. –Single currency interest rate swap “Plain vanilla” fixed-for-floating swaps are often just called 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. 14-3

Size of the Swap Market  In 2009 the notational principal of: –Interest rate swaps was $349.2 trillion USD. –Currency swaps was $16.5 trillion USD.  The most popular currencies are: –U.S. dollar –Japanese yen –Euro –Swiss franc –British pound sterling 14-4

The Swap Bank  Swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.  The swap bank can serve as either a broker or a dealer. –As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. –As a dealer, the swap bank stands ready to accept either side of a currency swap and then later lay off the risk, or match it with a counterparty. 14-5

Swap Market Quotations  Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs.  They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. 14-6

Interest Rate Swap Quotations Euro-€£ SterlingSwiss francU.S. $ BidAskBidAskBidAskBidAsk 1 year year year year year year year year year year –3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR. The convention is to quote against U.S. dollar LIBOR. 14-7

Swap Quotations 3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR. Swap Bank Firm A Firm B €3.82%€3.85%$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 $40 million for three years. –Firm A wants to finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate. A has good credit and can borrow at LIBOR. –Firm B wants to finance an interest-rate-insensitive asset and thus wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow fixed at 5.5%.  The swap bank quotes a three-year swap as 5.1—5.2 (against dollar LIBOR). FixedFloating A5%LIBOR B5.50%LIBOR +.20% 14-9

Example of an Interest Rate Swap Firm A 5.10%LIBOR Bank X Swap Bank 5.0% If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.1—5.2, they can convert their fixed rate 5% debt into a floating rate debt at LIBOR – 0.10%. A’s all-in-cost = 5.0% + LIBOR – 5.10% = LIBOR – 0.10%

Example of an Interest Rate Swap Firm B 5.20% Bank Y Swap Bank LIBOR LIBOR +.2% If Firm B borrows floating from their bank at LIBOR % and takes up the swap bank on their offer of 5.1—5.2, they can convert their floating rate debt into a fixed rate debt at 5.40%. B’s all-in-cost = –LIBOR + LIBOR % % = 5.40%

Example of an Interest Rate Swap Firm B Firm A 5.20%5.10% LIBOR Swap Bank LIBOR The swap bank makes 10 basis points on the deal. The swap bank’s all-in-cost = –LIBOR + LIBOR – 5.20% % = –0.10% 14-12

Example of an Interest Rate Swap Firm B Firm A 5.20%5.10% Bank X Bank Y Swap Bank LIBOR 5.0% LIBOR +.2% The notional size is $40 million. The tenor is for 3 years. A earns $40,000 per year on the swap. B earns $40,000 per year on the swap. The swap bank earns $40,000 per year

Using a Swap to Transform a Liability  Firm A has transformed a fixed rate liability into a floater. –A is borrowing at LIBOR –.10% –A savings of 10 bp.  Firm B has transformed a floating rate liability into a fixed rate liability. –B is borrowing at 5.40% –A savings of 10 bp. Firm A 5.10%LIBOR Bank X Swap Bank 5.0% Firm B 5.20% Bank Y Swap Bank LIBOR LIBOR +.2% 14-14

What about the Principal?  In our “plain vanilla” interest-only interest rate swap, we did not mention swapping the Notational Principal.  It could be the case that Firm A exchanged principal with their lender, Bank X, and Firm B exchanged principal with their outside lender, Bank Y

Cash Flows of an Interest-Only Swap: T = 0 Firm B Firm A Bank X Bank Y Swap Bank $40,000,

Cash Flows of an Interest-Only Swap: T = 1 Firm B Firm A Bank X Bank Y Swap Bank $2,000,000 $1,280,000 Assume LIBOR = 3%. $1,200,000 $2,040,000 $2,080,000 Firm A saves $40,000 per year relative to borrowing at LIBOR = 3%. Firm B saves $40,000 per year relative to borrowing at 5.5%. The swap bank earns $40,000 per year

Cash Flows of an Interest-Only Swap: T = 2 $1,600,000 Firm B Firm A $2,040,000 Bank X Bank Y Swap Bank $2,000,000 $1,680,000 Assume LIBOR = 4%. $1,600,000 $2,080,000 Firm A saves $40,000 per year relative to borrowing at LIBOR = 4%. Firm B saves $40,000 per year relative to borrowing at 5.5%. The swap bank earns $40,000 per year

Cash Flows of an Interest-Only Swap: T = 3 $2,000,000 Firm B Firm A $2,040,000 Bank X Bank Y Swap Bank $42,000,000 $42,080,000 Assume LIBOR = 5%. $2,000,000 $2,080,000 Firm A saves $40,000 per year relative to borrowing at LIBOR = 4%. Firm B saves $40,000 per year relative to borrowing at 5.5%. The swap bank earns $40,000 per year

Example of a Currency Swap  Consider Firms A and B: –Firm A is a U.S. MNC who wants to finance a euro denominated asset in Italy, and therefore wants to borrow €40 million for 3 years. A can borrow euros at 6%. –Firm B is a French MNC who wants to finance a dollar denominated asset, and therefore wants to borrow $60 million for 3 years. B can borrow dollars at 8%.  The current exchange rate is $1.50 = € $€ A$7%€6% B$8%€5%

Euro-€U.S. $ BidAskBidAsk 3 year Suppose that the Swap Bank publishes these quotes. The convention is to quote against U.S. dollar LIBOR. $€ A$7%€6% B$8%€5% Firm A wants to finance a euro- denominated asset in Italy and wants to borrow euros. It can borrow euros at 6% or it can borrow euros at 5.2% by using a currency swap Example of a Currency Swap

$7.0% Example of a Currency Swap Euro-€U.S. $ BidAskBidAsk $€ A$7%€6% B$8%€5% Suppose that Firm A borrows $60m locally at $7% and then trades $60m for €40m at spot. Firm A €5.2% Swap Bank Bank X FOREX Market LIBOR $7.0% (The convention is to quote against U.S. dollar LIBOR.) $60m €40m Firm A then enters into 2 fixed for floating swaps

$7.2% Example of a Currency Swap Euro-€U.S. $ BidAskBidAsk $€ A$7%€6% B$8%€5% Suppose that Firm B borrows €40m locally at €5%, then trades €40m for $60m. Firm B €5.0% Bank Y Swap Bank FOREX Market LIBOR €40m (The convention is to quote against U.S. dollar LIBOR.) €5% €40m $60m Firm B then enters into 2 fixed for floating swaps

Example of a Currency Swap Firm B Firm A $7.0%$7.2%€5.2% Bank X Bank Y Swap Bank €5.0% $7.0% €5.0% The notional size is $60m. The tenor is for 3 years. Firm A earns 80bp per year on the swap and hedges exchange rate risk. Firm B earns 80bp per year on the swap and hedges exchange rate risk. The swap bank earns 40bp per year (20bp in $ and 20bp in €)

Cash Flows of the Swaps: T = 0 Firm B Firm A Bank X Bank Y Swap Bank $60,000,000 €40,000,000 Foreign Exchange Spot Market €40,000,000 $60,000,000 €40,000,000 $60,000,

Cash Flows of the Swaps: T = 1 Firm B Firm A Swap Bank $4.32m €2m $1.8m $4.2m €2.08m $1.8m Bank X Bank Y Assume LIBOR = 3%. $4.2m €2m Firm A’s all-in-cost = €2.08m or 5.2% of €40m Firm B’s all-in-cost = $4.32 or 7.2% of $60m The swap bank earns €80,000 + $120,000 or.002×€40m +.002×$60m per year

Cash Flows of the Swaps: T = 2 Firm B Firm A Swap Bank $4.32m €2m $2.4m $4.2m €2.08m $2.4m Bank X Bank Y Assume LIBOR = 4%. $4.2m €2m Firm A’s all-in-cost = €2.08m or 5.2% of €40m Firm B’s all-in-cost = $4.32 or 7.2% of $60m The swap bank earns €80,000 + $120,000 or.002×€40m +.002×$60m per year

Cash Flows of the Swaps: T = 3 Firm B Firm A Swap Bank $4.32m€2m$3m $4.2m€2.08m$3m Bank X Bank Y Assume LIBOR = 5%. $64.2m €42m Foreign Exchange Forward Market $60m €40m $60m €40m 14-28

Equivalency of Currency Swap Debt Service Obligations  We can assume that IRP holds between the €5% euro rate and the $7% dollar rate. –This is reasonable since these rates are, respectively, the best rates available for each counterparty who is well known in its national market. –According to IRP: $€ A$7%€6% B$8%€5% S t ($/€) = S 0 ($/€) × (1 + i $ ) t (1 + i € ) t S 1 ($/€) = $1.50×(1.07) 1 €1.00×(1.05) 1 $ €1.00 = 14-29

IRR %–$60.00$4.20 $64.20 The swap bank could borrow $60m at 7% and use a set of 3 forward contracts to redenominate the bond as a 5% euro bond. –€40m = –$60m× €1.00 $1.50 €2.75m = $4.20m × $1.50×(1.07) €1.00×(1.05) €2.70m = $4.20m × $1.50×(1.07) 2 €1.00×(1.05) 2 €40.44m = $64.20m × $1.50×(1.07) 3 €1.00×(1.05) 3 –€40.00 €2.75 €2.70 € % 14-30

7.00% IRR %–€40.00€2.00 €42.00 The swap bank could borrow €40m at 5% and use a set of 3 forward contracts to redenominate the bond as a 7% dollar bond. –$60m = –€40m× $1.50 €1.00 $3.06m = €2m × × €1.00×(1.05) $1.50×(1.07) $3.12m = €2m ×× €1.00×(1.05) 2 $1.50×(1.07) 2 $66.67m = €42m× €1.00×(1.05) 3 $1.50×(1.07) 3 –$60.00 $3.06 $3.12 $

The Quality Spread Differential  The Quality Spread Differential (QSD) represents the potential gains from a swap that can be shared between the counterparties and the swap bank.  There is no reason to presume that the gains will be shared equally.  The QSD is calculated as the difference between the differences. $€ A$7%€6% B$8%€5% QSD1%––1%= 2% 14-32

Variations of Basic Currency and Interest Rate Swaps  Currency swaps: –Fixed for fixed –Fixed for floating –Floating for floating –Amortizing  Interest rate swaps: –Zero-for floating –Floating for floating  For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit

Risks of Interest Rate and 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 has an unhedged position.  Basis risk –Basis risk may occur if the floating rates of the two counterparties are not pegged to the same index.  Exchange rate risk –In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated

Risks of Interest Rate and Currency Swaps (continued)  Credit risk –This is the major risk faced by a swap dealer, the risk that a counterparty will default on its end of the swap.  Mismatch risk –It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.  Sovereign risk –The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap

Valuation of an Existing Swap  A swap is a derivative security, so it can be priced in terms of the underlying assets.  How to valuate a swap: –Any swap’s value is the difference in the present values of the payment streams that are incoming and outgoing. –Plain vanilla, fixed for floating swaps get valued just like a pair of bonds. –Currency swaps get valued just like two nests of currency forward contracts

Swap Valuation Example  A currency swap has a remaining life of 18 months.  It involves exchanging interest at 14% on £20 million for interest at 10% on $30 million once a year.  The term structure of interest rates is currently flat in both the U.S. and the U.K. If the swap were negotiated today, the interest rates exchanged would be $8% and £11%. All rates were quoted with annual compounding.  The current exchange rate is $1.65 = £1.  What is the value of the swap (in USD) to the party paying dollars?

06 18 £2.8m –$3m Value of the swap to the party paying dollars: –$5,559,669 = $8,335,659 = £2.8m (1.11) ½ £2.8m (1.11) 3 /2 + $1.65 £1 × –$3m (1.08) ½ –$3m + (1.08) 3/2 $2,775,990 Swap Valuation Example (continued) 14-38

Second Swap Valuation Example  Find the dollar value today to the party paying dollars of a 7-year old swap with 3 years remaining maturity.  The swap calls for exchanging interest only on €10m at 5% for $15m at 3%. –Semiannual payments, and the last payment was yesterday. –Today’s exchange rate is $1.30/€ and the AAA rate is 2% in the U.S. and 2.5% in the euro zone

N6 I/Y2.5% CPTPV-€1,436, PMT€250,000 = (€10m ×.05) /2 (semi-annual pay bond) FV€0 (NOT €10m since this is an interest-only swap.) N6 I/Y2.0% CPTPV-$1,303, PMT$225,000 = ($15m ×.03) /2 (semi-annual pay bond) FV$0 (NOT $15m since this is an interest-only swap.) The value of this swap to the party paying dollars is $563, (= $1,867, – $1,303,982.21). dollar value = €1,436, × $1.30/€1 = $1,867, Find the value of the swap as the net value of a portfolio of two bonds: 1. Long a euro-denominated bond and 2. Short a dollar-denominated bond Swap Valuation Example 2 (continued)

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 of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures