1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 15 Interest Rate and Currency Swaps

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-2 Interest Rate & Currency Swaps: Learning Objectives Define interest rate risk and demonstrate how it can be managed Describe interest rate swaps and show how they can be used to manage interest rate risk Analyze how interest rate swaps and cross- currency swaps can be used to manage both foreign exchange and interest rate risk simultaneously

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-3 Interest Rate Risk All firms, domestic or multinational, are sensitive to interest rate movements The single largest interest rate risk of a non-financial firm is debt service (for an MNE, differing currencies have differing interest rates thus making this risk a larger concern – see exhibit) The second most prevalent source of interest rate risk is its holding of interest sensitive securities Ever increasing competition has forced financial managers to better manage both sides of the balance sheet

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-4 Exhibit 15.1 International Interest Rate Calculations

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-5 Interest Rate Risk Whether it is on the left or right hand side, the reference rate of interest calculation merits special attention –The reference rate is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation –Most common is LIBOR (London Interbank Offered Rate)

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-6 Exhibit 15.2 U.S. Dollar-Denominated Interest Rates (February 2004)

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-7 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

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-8 Credit and Repricing Risk Example: Consider a firm facing three debt strategies –Strategy #1: Borrow $1 million for 3 years at a fixed rate –Strategy #2: Borrow $1 million for 3 years at a floating rate, LIBOR + 2% to be reset annually –Strategy #3: Borrow $1 million for 1 year at a fixed rate, then renew the credit annually Although the lowest cost of funds is always a major criteria, it is not the only one

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-9 Credit and Repricing Risk Strategy #1 assures itself of funding at a known rate for the three years; what is sacrificed is the ability to enjoy a lower interest rate should rates fall over the time period Strategy #2 offers what #1 didn’t, flexibility (repricing risk). It too assures funding for the three years but offers repricing risk when LIBOR changes Strategy #3 offers more flexibility and more risk; in the second year the firm faces repricing and credit risk, thus the funds are not guaranteed for the three years and neither is the price

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-10 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

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-11 Exhibit 15.3 Treasury Policy Statements

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-12 Trident’s Floating-Rate Loans Example using Trident corporation’s loan of US$10 million serviced with annual payments and the principal paid at the end of the third year –The loan is priced at US dollar LIBOR + 1.50%; LIBOR is reset every year –When the loan is drawn down initially (at time 0), an up-front fee of 1.50% is charged –Trident will not know the actual interest cost until the loan has been completely repaid

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-13 Exhibit 15.4 Trident Corporation’s Costs and Cash Flows in Servicing a Floating Rate Loan

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-14 Trident’s Floating-Rate Loans If Trident had wished to manage the interest rate risk associated with the loan, it would have a number of alternatives –Refinancing – Trident could go back to the lender and refinance the entire agreement –Forward Rate Agreements (FRAs) – Trident 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 – Trident could swap the floating rate note for a fixed rate note with a swap dealer

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-15 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 Trident wished to lock in the first payment it would buy an FRA which locks in a total interest payment at 6.50% –If LIBOR rises above 5.00%, then Trident would receive a cash payment from the FRA seller reducing their LIBOR payment to 5.0% –If LIBOR falls below 5.00% then Trident would pay the FRA seller a cash amount increasing their LIBOR payment to 5.00%

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-16 Interest Rate Futures Interest Rate futures are widely used; their popularity stems from high liquidity of interest rate futures markets, simplicity in use, and the rather standardized interest rate exposures firms posses 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 –Example: March ’03 contract with settlement price of 94.76 gives an annual yield of 5.24% (100 – 94.76)

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-17 Exhibit 15.5 Eurodollar Futures Prices

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-18 Interest Rate Futures If Trident wanted to hedge a floating rate payment due in March ’03 it would sell a futures contract, or short the contract –If interest rates rise, the futures price will fall and Trident can offset its interest payment with the proceeds from the sale of the futures contracts –If interest rates rise, the futures price will rise and the savings from the interest payment due will offset the losses from the sale of the futures contracts

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-19 Exhibit 15.6 Interest Rate Futures Strategies for Common Exposures

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-20 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

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-21 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 it 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

22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-22 Exhibit 15.7 Interest Rate Swap Strategies

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-23 Comparative Advantage Companies of different credit quality are treated differently by the capital markets For example, Unilever (U.K.) and Xerox (U.S.) are both in the market for $30 million of debt for a five- year period Unilever is an AAA credit rating (the highest), and therefore has access to both fixed and floating interest rate debt at attractive rates Unilever would prefer to borrow at floating rates, since it already has fixed-rate funds and wishes to increase the proportion of its debt portfolio which is floating

24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-24 Comparative Advantage Xerox has a BBB credit rating (the lowest major category of investment grade debt ratings), and would prefer to raise the debt at fixed rates of interest Although Xerox has access to both fixed-rate and floating-rate finds, the fixed-rate debt is considered expensive The firms, through Citibank, could actually borrow in their relatively ‘advantaged’ markets and then swap their debt service payments

25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-25 Exhibit 15.8 Comparative Advantage and Structuring a Swap Agreement

26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-26 Trident Corporation: Swapping to Fixed Rates Maria Gonzalez (Trident’s CFO) is concerned about the floating rate loan –Maria thinks that rates will rise over the life of the loan and wants to protect Trident from an increased interest payment –Maria believes that an interest rate swap to pay fixed/receive floating would be Trident’s best alternative –Maria contacts the bank and receives a quote of 5.75% against LIBOR; this means that Trident will receive LIBOR and pay out 5.75% for the three years

27. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-27 Trident Corporation: Swapping to Fixed Rates The swap does not replace the original loan, Trident must still make its payments at the original rates; the swap only supplements the loan payments Trident’s 1.50% fixed rate above LIBOR must still be paid along with the 5.75% as per the swap agreement; however, Trident now receives LIBOR thus offsetting the floating rate risk in the original loan Trident’s total payment will therefore be 7.25% (5.75% + 1.50%)

28. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-28 Exhibit 15.9 Trident Corporation’s Interest Rate Swap to Pay Fixed/Receive Floating

29. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-29 Trident Corp: Swapping Dollars into Swiss francs After raising the $10 million in floating rate financing and swapping into fixed rate payments, Trident decides it would prefer to make its debt-service payments in Swiss francs –Trident signed a 3-year contract with a Swiss buyer, thus providing a stream of cash flows in Swiss francs Trident would now enter into a three-year pay Swiss francs and receive US dollars currency swap –Both interest rates are fixed –Trident will pay 2.01% (ask rate) fixed Sfr interest and receive 5.56% (bid rate) fixed US dollars

30. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-30 Exhibit 15.10 Interest Rate and Currency Swap Quotes

31. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-31 Trident Corp: Swapping Dollars into Swiss francs The spot rate in effect on the date of the agreement establishes what the notional principal is in the target currency –In this case, Trident is swapping into francs, at Sfr1.50/$. –This is a notional amount of Sfr15,000,000. Thus Trident is committing to payments of Sfr301,500 (2.01%  Sfr15,000,000 = Sfr301,500) –Unlike an interest rate swap, the notional amounts are part of the swap agreement

32. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-32 Exhibit 15.11 Trident Corporation’s Currency Swap: Pay Swiss Francs and Receive U.S. Dollars

33. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-33 Trident Corporation: 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 with the Swiss buyer terminates after one year, Trident 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

34. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-34 Trident Corporation: Unwinding Swaps If Trident has two payments of Sfr301,500 and Sfr15,301,500 remaining (interest plus principal in year three) and the 2 year fixed rate for francs is now 2.00%, the PV of Trident’s commitment is francs is

35. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-35 Trident Corporation: 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 5.50%

36. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-36 Trident Corporation: Unwinding Swaps Trident’s currency swap, if unwound now, would yield a PV of net inflows of $10,011,078 and a PV of net outflows of Sfr15,002,912. If the current spot rate is Sfr1.4650/$ the net settlement of the swap is Trident makes a cash payment to the swap dealer of $229,818 to terminate the swap –Trident lost on the swap due to franc appreciation

37. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-37 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

38. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-38 A Three-way Cross Currency Swap Sometimes firms enter into loan agreements with a swap already in mind, thus creating a debt issuance coupled with a swap from its inception –Example: the Finnish Export Credit agency (FEC), the Province of Ontario, Canada and the Inter-American Development Bank (IADB) all possessed access to ready sources capital but wished debt service in another market –FEC had not raised capital in Canadian dollar Euromarkets and an issuance would be well received; however the FEC had a need for increased debt-service in US dollars, not Canadian dollars

39. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-39 A Three-way Cross Currency Swap –Province of Ontario needed Canadian dollars but due to size of provincial borrowings knew that issues would push up its cost of funds; there was however an attractive market in US dollars –IADB had a need for additional US dollar denominated debt- service; however it already raised most of its debt in the US markets but was a welcome newcomer in the Canadian dollar market Each borrower determined its initial debt amounts and maturities expressly with the needs of the swap

40. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-40 Exhibit 15.12 A Three-Way Back-to-Back Cross-Currency Swap

41. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-41 Summary of Learning Objectives The single largest interest rate risk of the non-financial firm is debt-service. The debt structure of an MNE will possess differing maturities of debt, different interest rates and different currency denominations The increasing volatility of world interest rates, combined with increasing use of short-term and variable-rate notes has led many firms to actively manage their interest rate risk

42. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-42 Summary of Learning Objectives The primary sources of interest rate risk to an MNE are short-term borrowing and investing and long-term borrowing The techniques and instruments used in interest rate risk management resemble those used in currency risk management: the old method of lending and borrowing The primary instruments include forward rate agreements (FRAs), interest rate futures, forward swaps and interest rate swaps

43. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 15-43 Summary of Learning Objectives The interest rate and currency swap markets allow firms that have limited access to specific currencies and interest rate structures to gain access at relatively low costs A cross currency interest rate swap allows a firm to alter both the currency of denomination of the cash flows but also to alter the fixed-to-floating or floating-to-fixed interest rate structure