Interest rate swaps, currency swaps and credit default swaps

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Presentation transcript:

Interest rate swaps, currency swaps and credit default swaps Chapter 21 Interest rate swaps, currency swaps and credit default swaps Websites: www.bis.org www.afma.com.au

Learning objectives Describe the nature of a swap and explain the structure and operation of vanilla and basis interest rate swaps Understand the importance of the interest rate swap market Examine the structure of a cross-currency swap and how they can be arranged Explain the rationale for the cross-currency swap markets Introduce the concepts and parties to credit default swaps Consider the risks for an intermediary, or a counterparty, to a swap

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.1 Interest rate swaps (cont.) Notional value of swap market transactions in 2010 Australian market Interest rate swaps AUD 5 923 billion Currency swaps AUD 23 963 billion Credit derivatives AUD 247 billion International markets Interest rate swaps USD 347 508 billion Currency swaps USD 16 347 billion Credit default swaps USD 30 261 billion Note: the figures are not comparable. The Australian market figures are annual turnover while the international figures are notional value at a point in time. (cont.)

21.1 Interest rate swaps (cont.) Swaps may be used to hedge interest risk and exchange rate risk, and also enable investors and borrowers to obtain a lower cost of funds or a higher yield Organised between borrowing parties The two parties swap their interest payment obligations No transfer of the principal amount Both parties benefit from the swap (cont.)

21.1 Interest rate swaps (cont.) Example: Table 21.1 outlines the current cost of funds for two borrowers Firm A has a credit advantage in both markets (cont.)

21.1 Interest rate swaps (cont.) Strategy Firm A borrows in a fixed market, where it has comparative advantage (i.e. 12%) Firm B borrows in another market (i.e. floating) at BBSW + 1.70%. One possible direct swap arrangement negotiable between firms A and B B pays A a fixed rate of 13.60% A pays B a floating rate of BBSW + 1.70% Figure 21.1 illustrates the flow of funds and benefits of this interest rate swap (cont.)

21.1 Interest rate swaps (cont.)

21.1 Interest rate swaps (cont.) The majority of swaps require the involvement of an intermediary, e.g. merchant bank, that often seeks an offsetting ‘matched swap’ It enters into opposite swap transactions to offset its net swap exposure, making a profit through a spread between the rates Figures 21.3 and 21.4 in the textbook illustrate intermediated interest rate swaps (cont.)

21.1 Interest rate swaps (cont.)

21.1 Interest rate swaps (cont.)

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.2 Rationale for the existence of interest rate swaps Reasons why the use of interest swaps has continued to grow Lowering the cost of funds (comparative advantage) Access gained to otherwise inaccessible debt markets Hedge interest rate risk exposures Profit margins locked in on economic transactions (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Lowering the net cost of funds (comparative advantage) For a comparative advantage to exist, the advantage in the fixed market must be different from that in the floating market (i.e. different risk premium) Why does this occur? Segmentation between floating and fixed debt markets Some types of institutions lend more heavily in floating markets (commercial banks) while others lend more heavily in fixed markets (life insurance offices, superannuation funds and unit trust funds) (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Lowering the net cost of funds (comparative advantage) (cont.) Despite exploitation of arbitrage opportunities that has reduced the possibility of profitable swap arbitrage arrangements, the interest rate swap market continues to grow for other reasons Table 21.2 indicates how interest rates in the two markets might adjust to remove the possibility of a profitable swap based on comparable advantage (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Gaining access to otherwise inaccessible debt markets Banks generally prefer lending at floating rates because it allows them to maximise their spread on loans when interest rates are changing Despite this, banks may provide limited funding to a client at fixed rates with the balance lent at floating rates Corporate borrowers able to issue fixed interest bonds must have a good credit rating Other borrowers obtain floating-rate funds from banks and use a swap to obtain a net fixed rate cost of funds (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Hedging existing interest rate exposures Example: a firm has an existing floating-rate loan and is concerned that floating rates will rise Strategy: the firm is able to synthesise (create) a fixed-cost loan by: paying a fixed rate to the swap counterparty receiving a floating payment from the counterparty Effect: if floating rate rises, firm’s payments to floating-rate lenders increases, but are matched by increase in receipts from swap counterparty, and payment to counterparty remains fixed (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Hedging existing interest rate exposures (cont.) Example: a firm has an existing fixed-rate liability and is concerned floating rates will fall Strategy: the firm is able to synthesise (create) a floating-rate cost of funds by: paying a floating rate to the swap counterparty receiving a fixed-rate payment from the counterparty Effect: fixed-rate payment received from counterparty is used to pay fixed-rate lenders, leaving the firm to make only a net floating-rate payment (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Locking in profit margins on economic transactions A manufacturer or provider of fixed-price goods or services is exposed to any movements in variable costs (such as floating-rate funds) and has an incentive to enter into a swap Locking in a net fixed-costs fund locks in a fixed-profit margin for the firm (cont.)

21.2 Rationale for the existence of interest rate swaps (cont.) Swaps in practice In reality more complex swap arrangements exist than the previous examples Swaps are likely to be more dynamic Existing swaps will be monitored and actively managed Swaps may be reversed when current interest rates change, or when interest rate expectations alter

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.3 Currency swaps Two parties exchange debt denominated in different currencies Interest payments are exchanged Principals are exchanged at the beginning of an agreement and then re-exchanged at the conclusion of the agreement, usually at the same exchange rate (cont.)

21.3 Currency swaps (cont.) (cont.) Example: Table 21.3 indicates there is a cost-of-funds benefit from the currency swap agreement of 0.50% per annum (cont.)

21.3 Currency swaps (cont.) (cont.) Example (cont.) Assuming X prefers USD and Y prefers AUD, a fixed-to-fixed currency swap strategy could be the following: Commencement of swap: currency swap X borrows AUD20 million and transmits it to Y Y borrows USD18.4 million and transmits it to X Exchange rate is AUD/USD0.9200 X and Y agree on the interest payment swap rates (cont.)

21.3 Currency swaps (cont.) (cont.)

21.3 Currency swaps (cont.) (cont.) Example (cont.) Interest payments X pays 11.50% in USD to Y Y pays 9.75% in AUD to X Both secure a cost of funds at 0.25% lower than if they had borrowed their preferred currency in their own right (cont.)

21.3 Currency swaps (cont.) (cont.)

21.3 Currency swaps (cont.) (cont.) Example (cont.) Effect Maturity of swap: currency re-exchange At conclusion of the swap agreement, principal amounts are re-exchanged along with the final interest payments X transmits USD18.4 million to Y Y transmits AUD20 million to X At original exchange rate of AUD/USD0.9200 Effect While FX risk is eliminated, both X and Y will need to obtain internally or purchase the relevant interest and principal amounts at the current exchange rate when due A notional FX gain or loss can still be made (cont.)

21.3 Currency swaps (cont.)

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.4 Rationale for the existence of currency swaps Currency swaps exist for the same reasons interest rate swaps are popular: Lowering the net cost of funds Gaining access to otherwise inaccessible debt markets Hedging interest rate (FX) risk exposures Locking in profit margins on economic transactions (cont.)

21.4 Rationale for the existence of currency swaps Lowering the net cost of funds Borrowers may obtain better terms by borrowing in different markets, including those denominated in foreign currencies; thus creating a need for currency swaps Hedging FX risk Two companies can follow their comparative advantage in the debt markets and enter a currency swap (cont.)

21.4 Rationale for the existence of currency swaps (cont.)

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.5 Credit default swaps (cont.) Credit risk Possibility that an obligor (borrower) will not meet a future financial commitment (interest or principal) to a lender Credit default swap (CDS) An agreement transferring credit risk from the protection buyer to the protection seller on the payment of a premium Premium paid by the protection buyer is typically a number of basis points relative to the credit protection amount (cont.)

21.5 Credit default swaps (cont.) Credit default swap (CDS) (cont.) CDS protection seller Institution that writes a CDS, accepting the credit risk of a reference entity and undertaking to compensate the protection buyer if a specified credit default event occurs Typically, insurance companies, banks, investment managers and hedge funds that have identified a capacity to accept higher levels of credit risk exposure in their balance sheets Reference entity An obligor (borrower) with a debt or loan obligation to the CDS protection buyer, e.g. a corporation or government (cont.)

21.5 Credit default swaps (cont.) Credit default swap (CDS) (cont.) CDS protection buyer Lender or investor buying a CDS to transfer risk associated with a reference entity Typically, banks, portfolio managers and multinational corporations that have identified a need to manage a credit risk exposure in their balance sheets The CDS specifies a credit default event E.g. bankruptcy, obligation acceleration, obligation default, cash payment failure, repudiation or moratorium of debt by a nation state (cont.)

21.5 Credit default swaps (cont.) Credit default swap (CDS) (cont.) In the event of credit default by the reference entity the most common forms of settlement are: Physical settlement Protection buyer delivers the agreed notional value of the debt of the reference entity to the protection seller and receives payment of that amount by the protection seller Cash settlement Protection seller pays a net cash amount to the protection buyer, usually based on the difference between the face value and the current market value of the underlying reference debt instruments (cont.)

21.5 Credit default swaps (cont.)

21.5 Credit default swaps (cont.) CDSs attracted a lot of attention during the GFC In particular, many of the ‘toxic’ mortgage securities were ‘insured’ by CDSs As the mortgage bond market and mortgage derivatives markets suffered large losses, the CDSs rose in value This market movement exposed issuers of CDSs to significant and rapidly growing liabilities American International Group (AIG) was most dramatically impacted.

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.6 Credit and settlements risk associated with swaps Credit risk Most swaps are through an intermediary Intermediary is at risk if one of the two counterparties defaults Intermediary is exposed to interest rate risk (i.e. uncertainty associated with fixed and floating markets) Exposure of intermediary limited to the difference between what a firm would have paid to, and received from, the intermediary Also occurs with currency swaps where a party defaults on the payment of interest or principal (cont.)

21.6 Credit and settlements risk associated with swaps (cont.) With currency swaps settlements risk occurs if one party settles an obligation within its time zone and the other party later defaults within a different time zone Significant time zone differentials can create this timing difference

Chapter organisation 21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

21.7 Summary Swaps facilitate the exchange of specified cash flows Interest rate swaps are used to: reduce the cost of borrowing manage existing interest rate exposures Currency swaps are used when an interest rate swap involves borrowing in different currencies Allow the management of interest rate and FX risk exposure Currency swaps differ from interest rate swaps in that the principal amounts raised by the two borrowers are swapped at commencement and re-exchanged at the end of the agreement