14 Interest Rate and Currency Swaps

INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Fifth Edition
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Chapter Objective:

This chapter discusses currency and interest rate
swaps, which are relatively new instruments for
hedging long-term interest rate risk and foreign
exchange risk.
14
Chapter Fourteen
Interest Rate and
Currency Swaps
14-1
Chapter Outline
Types of Swaps
Size of the Swap Market
The Swap Bank
Swap Market Quotations
Interest Rate Swaps
Currency Swaps
Variations of Basic Interest Rate and Currency Swaps
Risks of Interest Rate and Currency Swaps
Is the Swap Market Efficient?
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
Types of Swaps
The Swap Bank
Interest Rate Swaps
Currency Swaps
14-2
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.
14-3
In 2007 the notational principal of:
Interest rate swaps was $271.9 trillion USD.
Currency swaps was $12 trillion USD
The most popular currencies are:
U.S. dollar
Japanese yen
Euro
Swiss franc
British pound sterling
14-4
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.
14-5
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.
14-6
Interest Rate Swap Quotations
Euro- Sterling Swiss franc U.S. $
Bid Ask Bid Ask Bid Ask Bid Ask
1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57
2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94
3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13
4 year 3.06 3.09 5.12 5.17 1.73 1.81 4.25 4.28
5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39
6 year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50
7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58
8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66
9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72
10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79
3.823.85 means the swap bank will pay
fixed-rate euro payments at 3.82%
against receiving euro LIBOR or it will
receive fixed-rate euro payments at
3.85% against receiving euro LIBOR
The convention is to quote against U.S. dollar LIBOR.
14-7
Swap Quotations
3.823.85 means the swap bank will pay fixed-rate
euro payments at 3.82% against receiving dollar
LIBOR or it will receive fixed-rate euro payments at
3.85% against paying dollar LIBOR
Swap
Bank
Firm
A
Firm
B
3.82% 3.85%
$LIBOR $LIBOR
While most swaps are quoted against flat dollar
LIBOR, off-market swaps are available where
one party pays LIBOR plus or minus some number.
14-8
Example of an Interest Rate Swap
Consider firms A and B;
each firm wants to borrow
$40 million for 3 years.
Fixed Floating
A 5% LIBOR
B 5.50% LIBOR + .20%
Firm A wants finance an interest-rate-sensitive asset and
therefore wants to borrow at a floating rate.
A has good credit and can borrow at LIBOR
Firm B wants finance an interest-rate-insensitive asset and
therefore wants to borrow at a fixed rate.
B has less-than-perfect credit and can borrow at 5.5%
The swap bank quotes 5.15.2 against dollar LIBOR for a
3-year swap.
14-9
Firm
A
5.10%
LIBOR
Bank
X
Swap
Bank
If Firm A borrows from their bank at 5.0% fixed
and takes up the swap bank on their offer of
5.15.2 they can convert their fixed rate 5%
debt into a floating rate debt at LIBOR 0.10%
As all-in-cost:
= 5.0% + LIBOR 5.10% = LIBOR 0.10%
14-10
Firm
B
5.20%
Bank
Y
Swap
Bank
LIBOR
If Firm B borrows floating from their bank at
LIBOR + 0.20% and takes up the swap bank on
their offer of 5.15.2 they can convert their
floating rate debt into a fixed rate debt at 5.40%
Bs all-in-cost:
= LIBOR + LIBOR + 0.20% + 5.20% = 5.40%
14-11
Firm
B
Firm
A
5.20% 5.10%
LIBOR
Swap
Bank
LIBOR
The Swap Bank makes 10 basis points on the deal:
The Swap Banks all-in-cost:
= LIBOR + LIBOR 5.20% + 5.10% = 0.10%
14-12
Firm
B
Firm
A
5.20% 5.10%
Bank
X
Bank
Y
Swap
Bank
LIBOR LIBOR
The notional size is $40 million.
The tenor is for 3 years.
A earns $40,000 per year on the swap.
B earns $40,000 per year on the swap.
Swap Bank earns $40,000 per year.
14-13
Using a Swap to Transform a Liability
Firm A has transformed a fixed rate liability
into a floater.
A is borrowing at LIBOR .10%
A savings of 10 bp
Firm B has transformed a floating rate liability
into a fixed rate liability.
B is borrowing at 5.40%
A savings of 10 bp
14-14
What about the Principal?
In our plain vanilla interest-only interest
rate swap just given, we did not mention
swapping the Notational Principal.
It could be the case that firm A exchanged
principal with their lender (Bank X) and
firm B exchanged principal with their
outside lender, Bank Y.
14-15
Cash Flows of an Interest-Only Swap: T = 0
Firm
B
Firm
A
Bank
X
Bank
Y
Swap
Bank
14-16
Firm
B
Firm
A
Bank
X
Bank
Y
Swap
Bank
Assume LIBOR = 3%
$1,200,000 $1,200,000
$2,040,000 $2,080,000
A saves $40,000 per year relative to
borrowing at LIBOR = 3%.
B saves $40,000 per year relative to
borrowing at 5.5%.
14-17
$1,600,000
Firm
B
Firm
A
$2,040,000
Bank
X
Bank
Y
Swap
Bank
Assume LIBOR = 4%
$1,600,000
$2,080,000
borrowing at 5.5%.
14-18
$2,000,000
Firm
B
Firm
A
$2,040,000
Bank
X
Bank
Y
Swap
Bank
Assume LIBOR = 5%
$2,000,000
$2,080,000
borrowing at 5.5%.
14-19
Example of an Currency Swap
Firm A is a U.S. MNC and wants to
borrow 40 million for 3 years.
Firm B is a French MNC and wants to
borrow $60 million for 3 years
$
A $7% 6%
B $8% 5%
Firm A wants finance euro denominated asset in Italy and
therefore wants to borrow euro.
A can borrow euro at 6%
Firm B wants finance a dollar denominated asset and
therefore wants to borrow dollars.
B can borrow dollars at 8%
The current exchange rate is $1.50 = 1.00
14-20
Example of a Currency Swap
Euro- U.S. $
Bid Ask Bid Ask
3 year 5.00 5.20 7.00 7.20
Suppose that the Swap Bank publishes these quotes.
The convention is to quote against U.S. dollar LIBOR.
$
A $7% 6%
B $8% 5%
Firm A wants finance euro-denominated
asset in Italy and wants to borrow euro.
A can borrow euro at 6% or they can
borrow euro at 5.2% by using a
currency swap.
14-21
$7.0%
Euro- U.S. $
Bid Ask Bid Ask
5.00 5.20 7.00 7.20
$
A $7% 6%
B $8% 5%
Suppose that Firm A borrows
$60m at $7%; trades for at spot.
Firm
A
5.2%
Swap
Bank
Bank
X
FOREX Market
LIBOR
LIBOR
$7.0%
(The convention is to quote against U.S. dollar LIBOR.)
$60m
$
6
0
m

4
0
m

Firm A then enters in to 2
fixed for floating swaps.
14-22
$7.2%
Euro- U.S. $
Bid Ask Bid Ask
5.00 5.20 7.00 7.20
$
A $7% 6%
B $8% 5%
Suppose that Firm B borrows
40m at 5%, trades for $.
Firm
B
5.0%
Bank
Y
Swap
Bank
FOREX Market
LIBOR
LIBOR
40m
(The convention is to quote against U.S. dollar LIBOR.)
5%
4
0
m

$
6
0
m

Firm B then enters in to 2
fixed for floating swaps.
14-23
Firm
B
Firm
A
$7.0% $7.2%
5.2%
Bank
X
Bank
Y
Swap
Bank
5.0%
The notional size is $60m.
The tenor is for 3 years.
Firm A earns 80 bp per year on the swap and
hedges exchange rate risk.
Firm B earns 80 bp per year on the swap
and hedges exchange rate risk.
Swap Bank earns 40 bp per year (20bp in $ and 20bp in ).
14-24
Cash Flows of the Swaps: T = 0
Firm
B
Firm
A
Bank
X
Bank
Y
Swap
Bank
Foreign Exchange
Spot Market
14-25
Firm
B
Firm
A
Swap
Bank
$4.32m
2m
$1.8m
$1.8m
$4.2m
2.08m
$1.8m
$1.8m
Bank
X
Bank
Y
Assume LIBOR = 3%
Firm As all-in-cost
2.08m or
5.2% of 40m
Firm Bs all-in-cost
$4.32 or
7.2% of $60m
Swap bank earns 80,000 + $120,000
or .00240m + .002$60m per year.
14-26
Firm
B
Firm
A
Swap
Bank
$4.32m
2m
$2.4m
$2.4m
$4.2m
2.08m
$2.4m
$2.4m
Bank
X
Bank
Y
Assume LIBOR = 4%
14-27
Firm
B
Firm
A
Swap
Bank
$4.32m
2m
$3m
$3m
$4.2m
2.08m
$3m
$3m
Bank
X
Bank
Y
Assume LIBOR = 5%
Foreign Exchange
Forward Market
14-28
Example of a Direct Currency Swap
Firm
B
Firm
A
$7.0%
Bank
X
Bank
Y
5.0%
The problem is of course that the swap
bank is acting as a broker (or even a
dealer) and providing a servicethats
why they get paid.
Signing 1 contract is less work than 4.
$
A $7% 6%
B $8% 5%
If firms A and B knew and trusted each
other, they could theoretically cut out the
swap bank:
14-29
Equivalency of Currency Swap
Debt Service Obligations
We can assume that IRP holds between the 5%
euro rate and the $7% dollar rate.
This is reasonable since these rates are, respectively, the
best rates available for each counterparty who is well
known in its national market.
According to IRP:
$
A $7% 6%
B $8% 5%
S
t
($/) = S
0
($/)
(1 + i
$
)
t
(1 + i
)
t
S
1
($/) =
$1.50(1.07)
1
1.00(1.05)
1
$1.5286

1.00

=
14-30
IRR 0 1 2 3
7.00% $60.00 $4.20 $4.20 $64.20
5.00% 40.00 2.75 2.70 40.44
The swap bank could borrow $60m at 7% and use a set of 3
forward contracts to redenominate their bond as a 5% euro
bond.
40m = $60m
1.00

$1.50

2.7477m = $4.20m
$1.50(1.07)

1.00(1.05)

2.6963m = $4.20m
$1.50(1.07)
2
1.00(1.05)
2
40.4446m = $64.20m
$1.50(1.07)
3
1.00(1.05)
3
14-31
IRR 0 1 2 3
5.00% 40.00 2.00 2.00 42.00
7.00% $60.00 $3.06 $3.12 $66.67
The swap bank could borrow 40m at 5% and use a set of 3
forward contracts to redenominate their bond as a 7% dollar
bond.
$60m = 40m
$1.50

1.00

$3.06m = 2m
1.00(1.05)

$1.50(1.07)

$3.12m = 2m
1.00(1.05)
2
$1.50(1.07)
2
$66.67m = 42m
1.00(1.05)
3
$1.50(1.07)
3
14-32
Equivalency of Currency Swap Debt
Service Obligations
The ability to hedge with covered interest arbitrage
is where the swap bank found the 5% and $7%
rates
Euro- U.S. $
Bid Ask Bid Ask
5.00 5.20 7.00 7.20
Competition from other swap banks will keep their
spreads from getting too widethe theoretical
limit is 200 basis points total. (See QSD on next
slide.)
14-33
The QSD
The Quality Spread Differential 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.
$
A $7% 6%
B $8% 5%
QSD 1% 1% = 2%
The QSD is calculated
as the difference
between the differences.
14-34
Comparative Advantage
as the Basis for Swaps
$
A $7% 6%
B $8% 5%
A has a comparative advantage in borrowing in
dollars.
B has a comparative advantage in borrowing in
euro.
14-35
Variations of Basic Currency and
Interest Rate Swaps
Currency Swaps
fixed for fixed
fixed for floating
floating for floating
amortizing
Interest Rate Swaps
zero-for floating
floating for floating
For a swap to be possible, a QSD must exist.
Beyond that, creativity is the only limit.
14-36
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.
14-37
Risks of Interest Rate
and Currency Swaps (continued)
Credit Risk
This is the major risk faced by a swap dealerthe risk
that a counter party will default on its end of the swap.
Mismatch Risk
Its 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.
14-38
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.
14-39
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
14-40
Sample Interest Rate Swap Problem
A is a credit-worthy firm
A can borrow at 8% fixed
A can borrow at flat LIBOR
A prefers to borrow floating
B is a less-credit-worthy firm
B can borrow at 9% fixed
B can borrow at LIBOR + %
B prefers to borrow fixed
Both firms want a 10-year maturity
Devise a swap that is mutually beneficial for A and B.
Follow the convention of pricing against flat LIBOR.
Fixed Floating
A 8% LIBOR
B 9% LIBOR +
14-41
Swap
Bank
Outside
Lender
X
Outside
Lender
Y
Fixed Floating
A 8% LIBOR
B 9% LIBOR +
QSD = 1% % = %
Step 1: A is better at borrowing fixed; B is better at
borrowing floating so have them borrow externally
according to their comparative advantage
Step 2: We are to quote the swap against flat LIBOR
8%
(Step 1)
LIBOR +
(Step 1)
LIBOR
(Step 2)
LIBOR
(Step 2)
Step 3: The QSD =
so we have 50 bp to
distribute among 3
players. Lets try 20 for
A and B,
(this leaves 10 bp
for the swap bank)
8.2%
(Step 3)
8.3%
Step 4: check our work
As all-in-cost:
LIBOR 0.2
Bs all-in-cost:
8.8%
Swap Bank Profit:
10 basis points
14-42
Sample Currency Swap Problem
A is an Italian firm
A can borrow in euro at 5% fixed
A prefers to borrow in dollars but faces $8% cost
B is an American firm
B has already borrowed in dollars at $8%
5 years ago they issued a 15-year bond
B now prefers to borrow in euro but faces 6% cost
Both firms want a 10-year maturity
Devise a feasible swap that eliminates exchange
rate risk for A and B
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Swap
Bank
Outside
LenderX
Outside
LenderY
Step 1: A is better at borrowing ;
B is better at borrowing $
so have them borrow externally according to their
comparative advantage
Step 2: We are to eliminate exchange rate risk for A and B
5%
(Step 1)
$8%
(Step 1)
$8%
(Step 2)
(Step 2)
Step 3: The QSD = so
we have 50 bp to distribute
among 3 players. Lets try
20 for A and B,
(this leaves 10 bp
for the swap bank)
$7.8%
(Step 3)
5.8%
Step 4: check our work
As all-in-cost:
$7.8%
Bs all-in-cost:
5.8%
Swap Bank Profit:
10 basis points at
current exchange rate
5%

14 Interest Rate and Currency Swaps

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