1. Currency & Interest Rate
swap
Currency & Interest Rate

2. 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.

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

4. 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

5. 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.

6. 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

7. 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.

8. 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.

9. 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 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.

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

11. 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

12. 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/ (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%

13. 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

14. 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%

15. 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 /8 = 1/8

16. 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%

17. 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.

18. 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.

19. 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.

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

21. 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%

22. 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%

23. 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).

24. 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.

25. 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.

26. 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:

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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

35. 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

36. Financial Risk Changes in interest rates foreign exchange rates
commodities prices

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

38. 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

39. 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

40. 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

41. 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.

42. 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

43. 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

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

45. 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.

46. 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.

47. 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.

48. 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

49. 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

50. 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

51. 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.

52. Types of Foreign Exchange Exposure
Transaction Exposure
Translation Exposure
Economic Exposure

53. 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

54. Type of FX Contracts
Forwards
Futures
Currency Swaps
Options