Swaps

Add a swap to a loan to change loans type Plain vanilla interest rate swap domestic currency denominated but involving different loan structures, fixed vs. floating rate loans Plain deal foreign currency swap same loan structure, fixed interest rate, but different currencies.

Interest Rate Swap

Swap interpretation: investing in one type and financing in another type Types = fixed versus floating rate Coy. B, due to higher credit rating, has an absolute advantage in both types

Plain Vanilla Interest Rate Swap

Coy. B has comparative advantage in fixed rate, interest advantage is greater Coy. A has comparative advantage in floating rate!!, interest disadvantage is less Coys. A and B, each has a comparative advantage in the type of loan each does not desire Preconditions of a viable swap

Interest Rate Swap

Page 2 depicts a specific swap Other swaps are possible: triangular region specified by the 3 inequalities on page 3 On border of triangle, one party does not gain; on vertex, two parties do not gain Gain = 65 basis points for all swaps

FX Swap
Canuck Avions de Ligne, Lte Case Comparative advantage requirement for a viable swap is satisfied CAL has comparative advantage in real, Garota has comparative advantage in C$ But CAL wants C$, Garota wants reais Add FX swap to financing in one currency; result: financing in the other currency

FX Swap
Interpretation: A portfolio (5-pack) of forward contracts with different maturities CAL buys real forward to hedge real loan Garota buys C$ forward to hedge C$ loan Implied forward rate common to all 5 maturities is BR7.824/C$ vs. spot rate of BR7.366/C$, qualitatively consistent with IRP.

FX Swap Effects
Garota obtains real financing at its prespecified required rate of 15%, this built into swap cash flow calculations CAL obtains C$ financing at 9.61%, calculated using the Excels IRR function CAL reduces its C$ financing cost by 89 basis points

Vias de Valdivia, SA
Determine the reference currency (Chilean peso) cost of financing in another currency (U$) via ex-post Uncovered Interest Parity Technique applies only to pure discount loan arrangement UIP: (1+ KU$) = (1+10%)(1+a) where KU$ is the Chilean peso cost of U$ financing and a is the annual appreciation of U$

Vias de Valdivia, SA
Construct sensitivity analysis graph: gauge sensitivity of Chilean peso cost to a Breakeven value of a is 36.36%, where the peso costs are equalized At projected a, peso debt is cheaper Better to borrow at 50% than at 10%!!!! 10% in U$s is 65% in Chilean pesos.

Bling-Bling Corporation
Must use IRR function, cannot use ex-post Uncovered Interest Parity, since loan not pure discount arrangement Complication: issue costs Issue cost % applies to the gross financing Gross-up the net financing

Bling-Bling Corporation
Yen cash flows must be forward hedged FX loan: sell loan proceeds at Bid, buy debt service at Ask Criterion: Minimize cost of financing in the reference currency (U$) Technique: determine vector of U$ cash flows, then apply IRR function

Hedging FX financing cash flows

Canuck Avions case: one swap. Bling-Bling case: five forward contracts Bling-Bling must buy JY288,659,794 forward for years 1, 2, 3, 4, 5 and JY7,216,494,880 for year 5. Valid comparison of reference currency vs. FX financing requires that the latter be fully hedged

Principal Repayment Arrangements

0. Zero-Coupon-type: only 1 debt service date. 1. Bond-type: pay only interest; at maturity repay entire principal. 2. Mortgage-type: fully amortized with equal annual debt service (blend of interest and principal repayment). 3. Type-3: Principal repaid in equal annual installments; debt service declines during loan life. Ranked from fastest to slowest pace of principal repayment: 3, 2, 1, 0. The higher the number, the faster the pace of principal repayment.

Equal annual repayment of principal (type 3 loan)

Borrow $1 at 10% over two years. Principal repayment = 0.5 per year. Interest payments: year1 = $1 x 10% = .1; year2 = $.5 x 10% = .05 Debt service: year1 = .5 + .1 = .6; year2 = .5 + .05 = .55 Cash flows: 1; -.6; -.55. IRR = 10%

Tabular format for type 3 loan

Year Principal Principal Interest Debt @Start Repay. Payment Service 1 .5 .1 = 1(10%) .05 = .5(10%) .6

.5

.5

.55

Pure discount or zero coupon loan

Net = $100, F = 5%, interest rate = 10%, maturity = 3 years Debt service occurs at only one point in time, end of year 3 (loans maturity) Debt service = 105.26(1.1)^3 =140.10 Cash flows: 100, 0, 0, -140.10 Cost = 11.9%

Effect of up-front fee on pace of principal repayment to minimize all-in cost

Borrow $1 over 2 years: 10% interest rate, 5% up-front fee Grossed-up principal = 1.05263 = 1/(1-.05) Mortgage-type loan: 1; -0.6065; -0.6065 implies cost = 13.9% Pure-discount bond: 1; 0 ; -1.27368 implies cost = 12.86% Choose slow pace of principal repayment to amortize upfront loan processing fee over longer effective time horizon (or bond duration). The faster the pace of principal repayment (other things equal), the higher the all-in cost.

No interest loan! (but loan processing fee charged)

F=5%: need Net=$100, Gross= $105.26 If pay @ end year 1: Cost = 5.26% since cash flows are 100, -105.26 If pay @ end year 2: Cost = 2.6% since cash flows are 100, 0, -105.26 Moral of the story: If incur up-front loan processing fee, choose longest maturity possible.

Effects of loan processing fee (F) and FX-denomination

Situation Pace of Principal Repayment to Reduce Financing Cost Slow
Fast Slow

Incur F; no FX
No F; appreciating FX No F; depreciating FX

Financing in FX
If FX is projected to depreciate or exhibits a forward discount, repay principal slooowly (zerocoupon-type is best), other things equal. If FX is projected to appreciate or exhibits a forward premium, perhaps repay principal ASAP (type-3 is perhaps best), other things equal. Why perhaps? In presence of loan processing fees, it is better to postpone principal repayment.

Covered/Uncovered Interest Parity: Implications

High interest rate currency trades at a forward discount and will depreciate. Low interest rate currency trades at a forward premium and will appreciate. The two effects work at cross purposes: one raises, the other lowers the cost of financing in the reference currency. Implication: Apply Excels IRR function!

Dubious Rules of Thumb

Definitions: soft currency, likely to depreciate; hard currency, likely to appreciate. Always finance in a soft currency. Problem: such a currency exhibits high interest rate. Always finance in a low interest currency. Problem: such a currency will likely appreciate. Low interest currencies are hard.

Attaching FX Derivatives
An arbitrage play: firm seeking financing must be able to sell the FX derivative at a higher price than that at which it buys the same FX derivative Financial institutions must face regulatory restrictions which preclude them from direct purchase of the FX derivative Dual currency or currency option bonds circumvent restrictions