1. Chapter 14 Interest Rate and Currency Swaps

2. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-2 Interest Rate Risk All firms – domestic or multinational, small or large, leveraged, or unleveraged – are sensitive to interest rate movements in one way or another. The single largest interest rate risk of the nonfinancial firm (our focus in this discussion) is debt service; the multicurrency dimension of interest rate risk for the MNE is of serious concern. The second most prevalent source of interest rate risk for the MNE lies in its holdings of interest-sensitive securities.

3. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-3 Management of Interest Rate Risk Before they can manage interest rate risk, treasurers and financial managers of all types must resolve a basic management dilemma: the balance between risk and return. Treasury has traditionally been considered a service center (cost center) and is therefore not expected to take positions that incur risk in the expectation of profit (treasury management practices are rarely evaluated as profit centers). Treasury management practices are therefore predominantly conservative, but opportunities to reduce costs or actually earn profits are not to be ignored.

4. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-4 Management of Interest Rate Risk Both foreign exchange and interest rate risk management must focus on managing existing or anticipated cash flow exposures of the firm. As in foreign exchange management exposure, the firm cannot undertake informed management or hedging strategies without forming expectations – a directional and/or volatility view – of interest rate movements. Fortunately, interest rate movements have historically shown more stability and less volatility than foreign exchange rate movements. Once management has formed expectations about future interest rate levels and movements, it must choose the appropriate implementation, a path that includes the selective use of various techniques and instruments.

5. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-5 Management of Interest Rate Risk Prior to describing the management of the most common interest rate pricing risks, it is important to distinguish between credit risk and repricing risk. Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s credit worthiness, at the time of renewing a credit, is reclassified by the lender (resulting in changes to fees, interest rates, credit line commitments or even denial of credit). Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset.

6. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-6 Management of Interest Rate Risk As an example, Carlton Corporation has taken out a three-year, floating-rate loan in the amount of US$10 million (annual interest payments). Some alternatives available to management as a means to manage interest rate risk are as follows: –Refinancing –Forward rate agreements –Interest rate futures –Interest rate swaps

7. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-7 Management of Interest Rate Risk A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal. These contracts are settled in cash. The buyer of an FRA obtains the right to lock in an interest rate for a desired term that begins at a future date. The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate.

8. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-8 Management of Interest Rate Risk Unlike foreign currency futures, interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies. Their popularity stems from the relatively high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest- rate exposures most firms possess. The two most widely used futures contracts are the Eurodollar futures traded on the Chicago Mercantile Exchange (CME) and the US Treasury Bond Futures of the Chicago Board of Trade (CBOT).

9. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-9 Management of Interest Rate Risk Interest rate futures strategies for common exposures: –Paying interest on a future date (sell a futures contract/short position) If rates go up, the futures price falls and the short earns a profit (offsets loss on interest expense) If rates go down, the futures price rises and the short earns a loss –Earning interest on a future date (buy a futures contract/long position) If rates go up, the futures price falls and the short earns a loss If rates go down, the futures price rises and the long earns a profit

10. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-10 Management of Interest Rate Risk Swaps are contractual agreements to exchange or swap a series of cash flows. These cash flows are most commonly the interest payments associated with debt service, such as the floating-rate loan described earlier. –If the agreement is for one party to swap its fixed interest rate payments for the floating interest rate payments of another, it is termed an interest rate swap –If the agreement is to swap currencies of debt service obligation, it is termed a currency swap –A single swap may combine elements of both interest rate and currency swaps

11. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-11 Management of Interest Rate Risk The swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment. What is often termed the plain vanilla swap is an agreement between two parties to exchange fixed-rate for floating-rate financial obligations. This type of swap forms the largest single financial derivative market in the world.

12. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-12 Management of Interest Rate Risk Since all swap rates are derived from the yield curve in each major currency, the fixed- to floating-rate interest rate swap existing in each currency allow firms to swap across currencies. The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency. The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated. Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows (a significant reason for this being cost).

13. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-13 Carlton Corporation: Swapping to Fixed Rates Carlton Corporation’s existing floating-rate loan is now the source of some concern. Recent events have led management to believe that interest rates, specifically LIBOR, may be rising in the three years ahead. As the loan is relatively new, refinancing is considered too expensive but management believes that a pay fixed/receive floating interest rate swap may be the better alternative for fixing future interest rates now. This swap agreement does not replace the existing loan agreement; it supplements it. Note that the swap agreement applies only to the interest payments on the loan and not the principal payments.

14. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-14 Carlton Corporation: Swapping Floating Dollars into Fixed-Rate Swiss Francs After raising US$10 million in floating-rate debt, and subsequently swapping into fixed- rate payments, management decides it would prefer to make its payments in Swiss francs. Since the company has a natural inflow of Swiss francs (sales contract) it may decide to match the currency of its debt denomination to its cash flows with a currency swap. Carlton now enters into a three-year pay Swiss francs and receive US dollars currency swap.

15. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-15 Carlton Corporation: Swapping Floating Dollars into Fixed-Rate Swiss Francs The three-year currency swap entered into by Carlton is different from the plain vanilla interest rate swap described in two important ways: –The spot exchange rate in effect on the date of the agreement establishes what the notional principal is in the target currency. –The notional principal itself is part of the swap agreement (because in a currency swap the notional principals are denoted in two currencies, the exchange rate between which is likely to change over the life of the swap).

16. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-16 Carlton Corporation: Unwinding Swaps As with all original loan agreements, it may happen that at some future date the partners to a swap may wish to terminate the agreement before it matures. 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 (Swiss francs) back to the home currency (US dollars) of the firm.

17. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-17 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 under the contract’s specifications. Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather than over-the-counter derivatives. Most exchanges, like the Philadelphia Stock Exchange or Chicago Mercantile Exchange are themselves counterparty to all transactions. The real exposure of an interest or currency swap is not the total notional principal, but the mark-to-market values of differentials in interest of currency interest payments.

18. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-18 Illustrative Case: A Three-Way Back-to-Back Cross-Currency Swap Individual firms often find special demands for their debt in select markets, allowing them to raise capital at several points lower there than in other markets. Thus, a growing number of firms are confronted with debt service in currencies that are not normal for their operations. The result has been a use of debt issuances coupled with swap agreements from inception. The following exhibit depicts a three-way borrowing plus swap structure between a Canadian province, a Finnish export agency, and a multilateral development bank.

19. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-19 Exhibit 14.10 A Three-way Back-to-Back Cross-Currency Swap Finish Export Credit (Finland) Province of Ontario (Canada) Inter-American Development Bank Borrows $390 million at US Treasury + 48 basis points $260 million $130 million Borrows C$300 million at Canadian Treasury + 47 basis points Borrows C$150 million at Canadian Treasury + 44 basis points C$300 million C$150 million

20. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-20 Chapter 14 Appendix: Advanced Topics in Interest Rate Management An interest rate cap is an option to fix a ceiling or maximum short-term interest-rate payment. The contract is written such that the buyer of the cap will receive a cash payment equal to the difference between the actual market interest rate and the cap strike rate on the notional principal, if the market rate rises above the strike rate. Like any option, the buyer of the cap pays a premium to the seller of the cap up front for this right.

21. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-21 Chapter 14 Appendix: Advanced Topics in Interest Rate Management An interest rate floor gives the buyer the right to receive the compensating payment (cash settlement) when the reference interest rate falls below the strike rate of the floor.

22. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-22 Chapter 14 Appendix: Advanced Topics in Interest Rate Management No theoretical limit exists to the specification of caps and floors. Most currency cap markets are liquid for up to ten years in the over-the-counter market, though the majority of trading falls between one and five years. An added distinction that is important to understanding cap maturity has to do with the number of interest rate resets involved. A common interest rate cap would be a two-year cap on three-month LIBOR.

23. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-23 Chapter 14 Appendix: Advanced Topics in Interest Rate Management The value of a capped interest payment is composed of three different elements (3-year, 3-month LIBOR reference rate cap): –The actual three-month payment –The amount of the cap payment to the cap buyer if the reference rate rises above the cap rate –The annualized cost of the cap

24. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-24 Chapter 14 Appendix: Advanced Topics in Interest Rate Management Interest rate floors are basically call options on an interest rate, and equivalently, interest rate floors are put options on an interest rate. A floor guarantees the buyer of the floor option a minimum interest rate to be received (rate of return on notional principal invested) for a specified reinvestment period or series of periods. The pricing and valuation of a floor is the same as that of an interest rate cap.

25. 14-25 Exhibit 14A.2 Profile of an Interest Rate Cap Interest Rate Payment (%) Actual 3-month LIBOR on reset date (%) 5.00 5.50 6.00 6.50 7.00 5.506.006.507.508.007.00 7.50 Uncovered interest rate payment Capped interest rate payment The effective “cap”

26. 14-26 Exhibit 14A.3 Profile of an Interest Rate Floor German firm’s effective investment rate (%) 6-month DM LIBOR on reset date (%) 4.00 4.50 5.00 5.50 6.00 4.505.005.506.507.006.00 6.50 Uncovered interest earnings Interest earnings with floor The effective “floor”

27. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-27 Chapter 14 Appendix: Advanced Topics in Interest Rate Management An interest rate collar is the simultaneous purchase (sale) of a cap and a sale (purchase) of a floor. The firm constructing the collar earns a premium from the sale of one side to cover in part of in full the premium expense of purchasing the other side of the collar. If the two premiums are equal, the position is often referred to as a zero-premium collar.

28. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-28 Exhibit 14A.4 Profile of an Interest Rate Collar Firm’s interest rate payment (%) Actual market interest rate (%) 0.00 2.00 4.00 6.00 8.00 0.51.53.55.56.54.5 Uncovered interest rate payment Interest rate cap 2.5 1.00 3.00 5.00 7.00 9.00 Interest rate floor Floor strike rate Cap strike rate

29. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14-29 Chapter 14 Appendix: Advanced Topics in Interest Rate Management The purchase of a swap option, a swaption, gives the firm the right but not the obligation to enter into a swap on a pre-determined notional principal at some defined future date at a specified strike rate. A firm’s treasurer would typically purchase a payer’s swaption, giving the treasurer the right to enter a swap in which they pay the fixed rate and receive the floating rate.