1. Interest Rate and Currency Swaps
Chapter 14
Interest Rate and Currency Swaps

2. Interest Rate and Currency Swaps
Interest rate risk management
Interest rate swaps
Use of interest rate swaps and cross-currency swaps to manage both foreign exchange and interest rate risk simultaneously

3. Interest Rate Risk All firms are sensitive to interest rate movements
The largest interest rate risk of a non-financial firm is debt service (liability management)
For an MNE, differing currencies have differing interest rates thus making this risk a larger concern
The second most prevalent source of interest rate risk is its holding of interest sensitive securities (asset management)
Whether it is on the left or right hand side of the balance sheet, the reference rate of interest calculation is important
The reference rate is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation
Most common reference rate is LIBOR (London Interbank Offered Rate)

4. Management of Interest Rate Risk
The management dilemma is the balance between risk and return
Since most treasuries do not act as profit centers, their management practices are typically conservative
Before treasury can take any hedging strategy, it must first form an expectation or a directional and/or volatility view
Once management has formed its expectations about future interest rate levels and movements, it must then choose the appropriate implementation of a strategy

5. Credit and Repricing Risk
Credit Risk or roll-over risk is the possibility that a borrower’s creditworthiness at the time of renewing a credit, is reclassified by the lender
This can result in higher borrowing rates, fees, or even denial
Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is being reset

6. Floating-Rate Loans
If a firm wants to manage the interest rate risk associated with a loan, it would have a number of alternatives
Refinancing – The firm could go back to the lender and refinance the entire agreement
Forward Rate Agreements (FRAs) – The firm could lock in the future interest rate payment in much the same way that exchange rates are locked in with forward contracts
Interest Rate Futures
Interest Rate Swaps – The firm could swap the floating rate note for a fixed rate note with a swap dealer

7. Forward Rate Agreements (FRAs)
A forward rate agreement is an interbank-traded contract to buy or sell interest rate payments on a notional principal
Example: If a firm wishes to lock in a debt payment which is currently floating (LIBOR %) it can buy an FRA which locks in a total interest payment at 5.50%
If LIBOR rises above 5.00%, then the firm would receive a cash payment from the FRA seller reducing their LIBOR payment to 5.0%
If LIBOR falls below 5.00% then the firm would pay the FRA seller a cash amount increasing their LIBOR payment to 5.00%

8. Interest Rate Futures
Interest Rate futures (Treasury bonds, notes, and bills futures):
high liquidity of interest rate futures markets
simplicity in use
standardized interest rate exposures
Traded on an exchange; two most common are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT)
The yield is calculated from the settlement price (Treasury Bills futures only, contract size is $1mil for 90-day Treasury Bills)
Example: March 2XX9 contract with settlement price of gives an annual yield of 2.64% (100 – 97.36)

9. Interest Rate Futures
If a firm wants to hedge a floating rate payment due in April 2XX9 it would sell a futures contract, or short the contract
If interest rates rise, the futures price will fall and the firm can offset its interest payment with the proceeds from the sale of the futures contracts
If interest rates fall, the futures price will rise and the savings from the interest payment due will offset the losses from the sale of the futures contracts

10. Strategies Using Interest Rate Futures

11. Interest Rate Swaps
Swaps are contractual agreements to exchange or swap a series of cash flows
If the agreement is for one party to swap its fixed interest payment for a floating rate payment, its is termed an interest rate swap
If the agreement is to swap currencies of debt service it is termed a currency swap
A single swap may combine elements of both interest rate and currency swap
The swap itself is not a source of capital but an alteration of the cash flows associated with payment

12. Interest Rate Swaps
If firm thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating in order to protect itself from rising debt-service payments
If firm thought that rates would fall it would enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt-service payments
The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments

13. Interest Rate Swaps

14. Interest Rate Swaps

15. Swapping Dollars and Swiss Francs

16. Swapping Dollars and Swiss Francs

17. Unwinding Swaps
As with the original loan agreement, a swap can be entered or unwound if viewpoints change or other developments occur
Assume that the three-year contract (creating the franc exposure for Chow Chemical) with the Swiss customer terminates after one year, the firm no longer needs the currency swap
Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates then converting the target currency back to the home currency

18. Unwinding Swaps
If Chow has one payment of Sfr50,327,500 (LIBOR % where LIBOR is 5%) and another one of Sfr1,032,327,500 (interest plus principal in year three) remaining and the 2 year fixed rate for francs is now 6.50%, the PV of Chow’s commitment in francs is

19. Unwinding Swaps
At the same time, the PV of the remaining cash flows on the dollar-side of the swap is determined using the current 2 year fixed dollar rate which is now 6.20%

20. Unwinding Swaps
Chow’s currency swap, if unwound now, would yield a PV of net inflows of $204,753,494 and a PV of net outflows of Sfr957,416,991. If the current spot rate is Sfr4.8010/$ the net settlement of the swap is
Chow receives a cash payment of $5,333,167 from the swap dealer to terminate the swap

21. Counterparty Risk
Counterparty Risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations
A firm entering into a swap agreement retains the ultimate responsibility for its debt-service
In the event that a swap counterpart defaults, the payments would cease and the losses associated with the failed swap would be mitigated
The real exposure in a swap is not the total notional principal but the mark-to-market value of the differentials