Currency Swaps and Swaps Markets Chapter 7 Currency Swaps and Swaps Markets Learning objectives  Swap contracts and the swaps market  Currency swaps – Swap pricing schedules – Hedging exposure to currency risk Interest rate swaps  Other types of swaps – Commodity price swaps – Etcetera

7.1 Growth of the Swaps Market A currency swap is an agreement in which two counterparties exchange a stream of cash flows in one currency for a stream of cash flows in another currency. – Interest payments usually are exchanged, although the notional principal may or may not be exchanged. – The most common currency swap is a fixed-for-floating currency coupon swap.

7.1 Growth of the Swaps Market Development of the swaps market 1981 Salomon Brothers engineers the first currency swap between the World Bank and IBM. Early 1980s Customized, low-volume, high-margin deals. Late 1980s Commercial and investment banks become dealers. Swaps turn into a standardized, high-volume, low-margin business. Volume and liquidity grow.

7.1 Growth of the Swaps Market OTC derivatives notional outstanding ($ trillions) Sources: International Swap Dealers Association (www.isda.org) and Bank for International Settlements (www.bis.org).

7.2 Swaps as Portfolios of Forward Contracts The basic concept of a swap “I’ll pay yours if you pay mine.” In a swap, two counterparties exchange one stream of cash flows for another. The cash flow streams are usually liabilities. For example, fixed dollar interest payments swapped with floating yuan interest payments. However, the concept works just as well with any financial assets.

7.2 Swaps as Portfolios of Forward Contracts Interest rate swap An agreement to exchange interest payments for a specific period of time on a principal amount: Most interest rate swaps are fixed-for-floating. Only the interest payments are exchanged so the principal is merely notional. Only the difference check needs to be exchanged.

7.2 Swaps as Portfolios of Forward Contracts Currency swap An agreement to exchange a principal amount of two currencies and, after a pre-arranged length of time, re-exchange the original principal. Unlike interest rate swaps, the notional principal may or may not be exchanged. Interest payments typically are exchanged, although sometimes the difference in value is settled with a difference check.

7.2 Swaps as Portfolios of Forward Contracts Commodity price swap A swap in which the principal amount on at least one side of the swap is a commodity such as oil or gold: The other side is usually an interest payment, although it could be another commodity or changes in the value of a commodity. The principal may or may not be notional. A difference check can settle changes in value, although some swap contracts call for physical delivery of the commodity.

7.3 Currency Swaps Example of a currency coupon swap Ford Motor Company (U.S.) Ford has $100 million in 2-year, fixed-rate dollar debt at 6.62% compounded semiannually (sa). Ford wants floating-rate Indian rupee debt. Tata Motors (India) TM has rupee 4.032 billion in 2-year, floating-rate rupee debt with semiannual payments priced at LIBOR+60 bps. TM wants fixed-rate U.S. dollar debt.

7.3 Currency Swaps Pricing schedule for a rupee-per-dollar (Rp/$) currency coupon swap Maturity Bid ($) Ask ($) 2 years 6.04% 6.20% All quotes are U.S. dollars semiannual actual/365 against 6-month LIBOR flat in rupees. S0Rp/$ = Rp 40.3200/$ Assume yield curves are flat, and the dollar is selling at a six-month forward premium of 2.04%.

7.3 Currency Swaps A note on day count conventions MMY = BEY (360/365) Adjusting for day count conventions Bond equivalent yields (BEY) are quoted as Actual/365 Money market yields (MMY) are quoted as Actual/360 The relation between the two is MMY = BEY (360/365)

7.3 Currency Swaps TM’s “uncovered” swap cash flows

7.3 Currency Swaps TM’s “fully covered” swap cash flows

7.3 Currency Swaps A “fully covered” swap (floating-for-fixed) 1. Convert the floating rate (MMY) spread to LIBOR into BEY = MMY (365/360). 2. Find the corresponding spread in the other currency from equation (7.2). (7.2) 3. Calculate the fixed rate payment from the spread and the swap ask rate.

7.3 Currency Swaps 1. Convert the floating rate (MMY) spread to LIBOR into BEY. TM’s 30 bp spread to LIBOR is quoted as a money market yield (MMY). The bond equivalent yield is BEY = MMY (365/360) = (30 bps) (365/360) = 30.4167 bps every six months or 60.8333 bps per year (sa)

7.3 Currency Swaps 2. Find the corresponding spread in the other currency. The $ swap mid-rate is 6.12% or i$ = 3.06 percent per six months. The dollar is at a 6-month forward premium of 2.04%, so the 6-month rupee interest rate is iRp = (1+i$)(F1Rp/$/S0Rp/$)–1 = (1.0306)(1.0204)–1 = 5.162424% per six months

7.3 Currency Swaps 2. Find the corresponding spread in the other currency. Equation (7.2) is used to find an equivalent fixed rate spread in another currency. (7.2) Yield curves are assumed flat, so these present value annuity factors (PVIFA) are useful: PVIFA$ (3.060000%, 4 periods) = 3.711771 PVIFARp (5.162424%, 4 periods) = 3.532613

7.3 Currency Swaps 2. Find the corresponding spread in the other currency. TM’s LIBOR spread is 30.4167 bps in rupees. Solving equation (7.2) for the equivalent dollar spread r$ results in (7.2) or r$ = (30.4167 bps) (3.532613 / 3.711771) = 28.9485 bps per six months

7.3 Currency Swaps 3. Calculate the payment from the swap ask rate and the spread. TM’s all-in cost of fixed rate dollar debt is 3.100000% (swap ask rate) + 0.289485% (spread) r$ = 3.389485% per six months = 6.778970% compounded semi-annually = an effective annual rate of (1.03389485)2 – 1 = 6.893857%

7.3 Currency Swaps Ford’s “uncovered” swap cash flows

7.3 Currency Swaps Ford’s “fully covered” swap cash flows

7.3 Currency Swaps A “fully covered” swap (fixed-for-floating) 1. Find the spread over the swap bid rate. 2. Find the corresponding spread in the other currency from equation (7.2). (7.2) 3. Convert this BEY spread to a MMY spread over LIBOR.

7.3 Currency Swaps 1. Calculate the spread to the swap bid rate. Ford’s dollar spread to the swap bid rate is 3.31% (fixed interest rate) – 3.02% (swap bid rate) r$ = 0.29% every six months ($)

7.3 Currency Swaps 2. Find the corresponding premium in the other currency. Solving equation (7.2) for the rupee spread rRp that yields the same present value as the dollar spread results in (7.2) or rRp = (29 bps) (3.711771 / 3.532613 ) = 30.4708 bps per six months (BEY)

7.3 Currency Swaps 3. Convert the BEY spread to a floating rate MMY spread. Ford’s 30.4708 bp spread is quoted as a bond equivalent yield (BEY). The corresponding money market yield is MMY = BEY (360/365) = (30.4708 bps) (360/365) = 30.0533 bps every six months Ford’s all-in cost of floating rate rupee debt is LIBOR + 60.1067 bps (sa).

7.3 Currency Swaps The swap bank’s “uncovered” cash flows

7.3 Currency Swaps The swap bank’s “fully covered” cash flows

7.3 Currency Swaps The swap bank’s “fully covered” cash flows BEY (Rp) = (0.0533 bps)(365/360) = 0.0540 bps BEY ($):  r$ = BEY ($) = 0.0515 bps, or 0.000515% The swap bank’s return as a dollar bond equivalent yield (BEY) = 0.079485% + 0.000515% = 0.08% or 8 bps per six-month period

7.4 Interest Rate Swaps Interest rate swaps An interest rate swap is the same as a currency swap, but in a single currency. A difference check is paid during the life of the swap. The notional principal is in a single currency and does not need to be swapped.

7.4 Interest Rate Swaps Floating-for-fixed conversion for an interest rate swap 1. Convert the floating rate (MMY) spread to LIBOR into BEY = MMY (365/360). 2. Find the corresponding spread in the other currency from equation (7.2). Step 2 is no longer necessary. 3. Calculate the fixed rate payment from the spread and the swap ask rate.

7.4 Interest Rate Swaps Fixed-for-floating conversion for an interest rate swap 1. Find the spread over the swap bid rate. 2. Find the corresponding spread in the other currency from equation (7.2). Step 2 is no longer necessary. 3. Convert this BEY spread to a MMY spread over LIBOR.

7.5 Other Types of Swaps Commodity swaps Commodity swaps are traded against a variety of commodity prices including Oil Gold Pork belly prices Most commodity swaps are fixed-for-floating swaps based upon spot prices

7.5 Other Types of Swaps An oil-for-euro swap A Dutch chemicals manufacturer uses 500,000 barrels of oil every 3 months. The manufacturer has contracted to sell its products at a fixed euro price for 5 years and wants to fix its input costs in euros as well.

Interest rate swap dealer 7.5 Other Types of Swaps An oil price swap Spot oil market Spot oil price Oil Dutch firm Spot oil price Commodity swap dealer Fixed rate ($s) Dutch firm Fixed rate ($s) Interest rate swap dealer LIBOR ($s) LIBOR ($s) Dutch firm Currency swap dealer Fixed rate (€s)

7.5 Other Types of Swaps A debt-for-equity swap A London bank holds a volatile portfolio of H-shares that is highly correlated with the Hang Seng China Enterprises index. The bank decides it would rather hold fixed-rate pound sterling debt. Combine the following three swaps to achieve the desired result: A fixed-for-floating £ interest rate swap A pound-for-HK$ currency swap An equity swap for fixed-rate HK$ debt

7.5 Other Types of Swaps Swapping H-shares for £s H-share portfolio H-share return London bank H-share return Equity swap dealer Fixed rate (HK$s) London bank Fixed rate (HK$s) Currency swap dealer LIBOR (£s) LIBOR (£s) London bank Interest rate swap dealer Fixed rate (£s)

7.5 Other Types of Swaps Swaptions A swaption is a swap with one or more options attached: Interest rate ceilings or floors Exchange rate caps Multiple options (e.g., cylinder options) The option component of a swaption is on the underlying fixed-rate bond and is priced accordingly.