1 Admin News  Final’s date: 60% liked 12/18 (Registrar-set date).  => So, final will be 12/18.  Some of you had emergency reasons & wound not be able to make it => expect an from me.  Quiz V next Tuesday…  If absolutely can’t come, please let me know…  Will try to accommodate you.  Otherwise, weight goes to final

2 Swaps (or parts of chapter 14)

3 Agenda  Interest rate risk? Credit & Repricing risks  What hedging strategy? Refinancing Forward Rate Agreement Interest Rate Future Interest Rate Swap Currency Swap (& how to undo them)  Counterparty Risk  Cross Currency Swaps (again )

4 Interest Rate Risk  Fact: all firms sensitive to interest rate changes.  MNE: differing currencies have differing interest rates => interest rate risk larger!  Reference rate rate of interest used in standardized quotation, loan agreement, or financial derivative valuation Most common: LIBOR (London Interbank Offered Rate).

5 Credit and Repricing Risk  Credit (roll-over ) Risk: risk of change of borrower creditworthiness when renewing credit.  Repricing risk: risk of changes in interest rates charged (earned) when financial contract rate is reset.  For Example: three debt strategies #1: Borrow $1 million for 3 fixed rate. #2: Borrow $1 million for 3 floating rate, LIBOR + 2% reset annually. #3: Borrow $1 million for 1 fixed rate, renew credit annually

6 How to hedge floating-rate loans risk?  Assume floating-rate loan for US$10 m.  Serviced w/ annual payments  Bullet principal end third year Loan US$ LIBOR %. LIBOR reset annually. At time 0, up-front fee of 1.50%. Do we know the actually cost?

7 Floating-Rate Loan: Example

8 How to manage a floating rate loan?  Alternatives Refinancing –refinance the entire agreement. Forward Rate Agreement (FRA) –lock in future interest rate payment (as w/ forex forward contracts). Interest Rate Futures Interest Rate Swaps –Could swap floating rate note for fixed rate note w/ swap dealer.

9 Forward Rate Agreement (FRA)  Interbank-traded contract to buy or sell interest rate payments on notional principal. E.g.: If you wish to lock in first payment, buy a FRA which locks total interest 6.5% –If LIBOR above 5% => receive cash payment from FRA seller reducing LIBOR payment to 5% –If LIBOR below 5% => pay FRA seller cash amount increasing LIBOR payment to 5% –So you locking in payment of 5%+1.5%!

10 Interest Rate Futures  Very often used (unlike forex futures) high liquidity of interest rate futures markets standardized interest rate exposures firms  Exchange-traded Chicago Mercantile Exchange (CME). Chicago Board of Trade (CBOT). London Intl Financial Futures & Options Exchange (LIFFE).  Yield calculated from settlement price ExposureActionInterest Rate Outcome Paying interest Short future Rates up Rates down P futures down (short: profit) P futures up (short: loss) Earning interest Long future Rates up Rates down P futures down (long: loss) P futures up (long: profit)

11 Eurodollar Futures (3 month), 11/19/03 Source: WSJ, 11/20/03

12 Interest Rate & Currency Swaps  Contractual agreements to exchange (swap) series of cash flows.  Commits each counterparty to exchange amount of regular intervals, until expiration.  Interest rate swap: agreement to swap fixed interest payment for floating rate payment.  Currency swap: agreement to swap currencies of debt service => initial currency exchange & maturity.  Swap may combine elements of both interest rate and currency swap.  Swap itself not source of capital!

13 Interest Rate Swaps Strategies  Swap = collection of forward contracts for exchange of maturities. reduces transaction costs. legal structure of swap transaction reduce counterparty risk.  Interest rate swap cash flows: interest rates applied to a notional principal, but no principal is swapped! PositionExpectationStrategy Fixed-Rate DebtRates up Rates down Stay put Pay floating/Receive Fixed Floating-Rate DebtRates up Rates down Pay fixed/Receive floating Stay put

14 Example: swapping to fixed rates  Expect rates will rise over life of loan.  => interest rate swap pay fixed/receive floating would be best.  Bank quotes you 5.75% against LIBOR  The swap does not replace the original loan, must still make payments at original rates!  Swap only supplements the loan payments!

15 Interest Rate Swap

16 Currency Swap  So far, raised $10m in floating rate financing & swap into fixed rate payments.  But, may prefer to make debt-service payments in SF.  => would enter into a 3-year pay Swiss francs & receive US$ swap Both interest rates fixed. Will pay 2.01% (ask rate) fixed SF interest & receive 5.56% (bid rate) fixed US$.  Spot rate on date of agreement establishes notional principal is in target currency Notional amount of SF 15,000,000. Commit to payments SF 301,500 (2.01%  SF15,000,000) The notional amounts part of swap agreement!

17 Currency Swap Source: Financial Times (as quoted by MSE)

18 Swapping US$ to Swiss Francs

19 Unwinding Swaps  Can unwind a swap if viewpoints changes…  Assume 3-year contract w/ Swiss buyer terminates in one year  How to unwind it? Discount remaining cash flows under swap current interest rates. Convert target currency back to home currency

20 Unwinding Swaps  Assume two payments left: SF301,500 & SF15,301,500  2-year fixed rate for SF is 2%  PV swap commitment  PV of remaining cash flows on the $-side of swap is determined using current 2 year fixed dollar rate 5.5%  PV net inflows $10,011,078.  PV net outflows SF 15,002,912.  If current spot SF 1.465/$ net settlement

21 Counterparty Risk  Potential exposure any firm bears that second party to financial contract will be unable to fulfill obligations.  A firm entering into a swap agreement retains the ultimate responsibility for its debt-service.  In event swap counterpart defaults, payments would cease.  The real exposure: not total notional principal, but mark-to-market value of differentials!

22 3-way Cross Currency Swap Province of Ontario (Canada) Borrows $390 US Treasury + 48 b.p. Finish Export Credit (Finland) Borrows C$300 Canadian Treasury + 47 b.p. Inter-American Development Bank Borrows C$150 Canadian Treasury + 44 b.p. $260 million C$300 million $130 million C$150 million Sometimes firms enter into loan agreements w/ swap already in mind, creating debt issuance coupled w/ swap from inception…

23 Things to remember…  Interest rate risk? Credit & Repricing risks  What hedging strategy? Refinancing Forward Rate Agreement Interest Rate Future Interest Rate Swap Currency Swap (& how to undo them)  Counterparty Risk.  Cross Currency Swaps.