Currency & Interest Rate swap Currency & Interest Rate

Currency & Interest Rate Swaps This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk.

Outline Types of Swaps Size of the Swap Market The Swap Bank Interest Rate Swaps Currency Swaps

Outline (continued) Swap Market Quotations Variations of Basic Currency and Interest Rate Swaps Risks of Interest Rate and Currency Swaps Swap Market Efficiency Concluding Points About Swaps

Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to 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.

Size of the Swap Market In 2001 the notational principal of: Interest rate swaps was $58,897,000,000. Currency swaps was $3,942,000,000 The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling

The Swap Bank A 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 their risk, or match it with a counterparty.

An Example of an Interest Rate Swap Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

An Example of an Interest Rate Swap Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent. Firm B would prefer to borrow at a fixed rate.

An Example of an Interest Rate Swap The borrowing opportunities of the two firms are:

An Example of an Interest Rate Swap Bank The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years 10 3/8% LIBOR – 1/8% Bank A

An Example of an Interest Rate Swap ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. Swap Bank 10 3/8% LIBOR – 1/8% Bank A 10%

An Example of an Interest Rate Swap The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼% Company B

An Example of an Interest Rate Swap ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank 10 ½% They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. LIBOR – ¼% Company B LIBOR + ½%

An Example of an Interest Rate Swap The swap bank makes money too. Swap Bank 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank A Company B LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼

An Example of an Interest Rate Swap The swap bank makes ¼% Swap Bank 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank A Company B A saves ½% B saves ½%

An Example of a Currency Swap Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds. This will give them exchange rate risk: financing a sterling project with dollars. They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.

An Example of a Currency Swap If they can find a British MNC with a mirror-image financing need they may both benefit from a swap. If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

An Example of a Currency Swap Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

An Example of a Currency Swap Bank $8% $9.4% £11% £12% Firm A Firm B $8% £12%

An Example of a Currency Swap A’s net position is to borrow at £11% Swap Bank $8% $9.4% £11% £12% Firm A Firm B $8% £12% A saves £.6%

An Example of a Currency Swap B’s net position is to borrow at $9.4% Swap Bank $8% $9.4% £11% £12% Firm A Firm B $8% B saves $.6%

An Example of a Currency Swap 1.4% of $16 million financed with 1% of £10 million per year for 5 years. The swap bank makes money too: Swap Bank $8% $9.4% £11% £12% Firm A Firm B $8% At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years. £12% The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).

The QSD The Quality Spread Difference represents the potential gains from the 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. In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

Comparative Advantage as the Basis for Swaps A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B A pays .4% less to borrow in pounds than B: A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds.

Comparative Advantage as the Basis for Swaps B has a comparative advantage in borrowing in £. B pays 2% more to borrow in dollars than A B pays only .4% more to borrow in pounds than A:

Comparative Advantage as the Basis for Swaps A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. If they borrow according to their comparative advantage and then swap, there will be gains for both parties.

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. For example, 6.60 — 6.85 means the swap bank will pay fixed-rate payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate payments at 6.85% against receiving dollar LIBOR.

Variations of Basic Currency and Interest Rate Swaps fixed for fixed fixed for floating floating for floating amortizing 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 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 counter party 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.

Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: Plain vanilla fixed for floating swap gets valued just like a bond. Currency swap gets valued just like a nest of currency futures.

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.

Concluding Remarks The growth of the swap market has been astounding. Swaps are off-the-books transactions. Swaps have become an important source of revenue and risk for banks

Managing Financial Risk Understand the basic difference between hedging and speculating Discern between the types of hedging strategies using futures, options, swaps, and products such as interest rate ceiling, floor, and collars Develop appropriate interest rate hedging strategies

Financial Risk Changes in interest rates foreign exchange rates commodities prices

Risk Profile Attitude towards risk for each potential exposure. Risk-return tradeoff. Basis for financial risk management.

Objectives of Financial Risk Management Determine Risk Profile Value at Risk(VAR) Set Basic Goals Identify and Measure the Level of Risk Exposure Manage Exposure Monitor Exposure

Hedging vs. Speculating A hedger has a cash position or an anticipated cash position that he or she is trying to protect from adverse interest rate movements A speculator has no operating cash flow position to protect and is trying to profit solely from interest rate movements

Some Important Terms Hedger Speculator Arbitrage Perfect vs imperfect hedge Pure vs anticipatory hedge Partial and cross hedge Long (buy) and short (sell) hedge Mark to market

Hedger Entity that uses financial instruments to reduce the price risks associated with his basic business activities. By assuming a position in the futures market that is equal and opposite to the position in the cash market, the hedger established a situation where losses in the cash market are offset by gains in the futures market and vice versa.

Speculator An entity who takes a position in the financial market that is not offset by an opposite position in a basic line of business. A speculator “bets” on the direction of the market and is willing to assume risk

Arbitrage Process by which buying in one market and selling in another Leads to a riskless profit. Arbitragers do not assume risk, but profit from market inefficiencies

Perfect vs Imperfect Hedge A perfect hedge is one where the individual is able to eliminate all risk of price fluctuations.

Pure vs Anticipatory Hedge A pure hedge is one where the individual assumes a position in the futures market equal and opposite to the current position in the cash market (such as hedging a riding the yield curve position). An anticipatory hedge is taking a position that is a temporary substitute for an anticipated position in the cash market.

Partial and Cross Hedge A partial hedge is where the person takes a position in the futures market that is smaller than the cash position. A cross hedge is where the manager uses a different hedging instrument (futures instrument) than the hedged cash instrument.

Long (buy) and Short (sell) Hedge A long hedge is where the firm BUYS a futures contract. A short hedge is where the firm SELLS a futures contract. A long hedge is appropriate when the firm will buy an asset in the future or sell a liability prior to maturity. A short hedge is appropriate when the firm issues a liability in the future or sells a current cash position in the future.

Mark to Market Everyday the gain or loss on a futures position causes your margin account to be adjusted, gains or credited to your account and losses or debited

Buy vs. Sell Hedge Type of hedge should depend on the nature of the cash flow position being hedged, not on the anticipated direction of interest rates. Buy Hedge: A future investment or retiring a liability prior to maturity Sell Hedge: Issue a liability in the future or sell an investment prior to its maturity

Why Hedges Are Not Perfect Futures contract in general have only four expiration dates per year. (Note T-bills: Mar, June, Sept, and Dec. Correlation coefficient of spot rates and futures rates is less than 1.0

Other Hedging Instruments Interest rate caps Purchaser pays a premium and receives cash payments from the cap seller when the reference rate exceeds strike rate. Interest rate floors Purchaser pays a premium for the rate floor contract, receives cash payment when reference rate falls below strike rate. Interest rate collars Purchase a rate cap and sell or issue a rate floor. Pay a premium for the cap and receive a premium for the floor.

Types of Foreign Exchange Exposure Transaction Exposure Translation Exposure Economic Exposure

Foreign Exchange Markets Spot Market and the Spot Foreign Exchange Rate Forward Market and the Forward Exchange Rate Forward Exchange Rate and Interest Rate Parity

Type of FX Contracts Forwards Futures Currency Swaps Options