Interest rate and currency swap market

Presented by: -
Vikas Singh
11/PMB/096
 Chapter Outline
 Types of
Types of Swaps
Swaps
 Size of
Size of the Swap Market
the Swap Market
 The Swap
The Swap Bank
Bank
 Swap Market
Swap Market Quotations
Quotations
 Interest Rate
Interest RateSwaps
Swaps
 Currency Swaps
Currency Swaps
 Variations of
Variations of Basic
Basic Interest Rate and
Interest Rate and Currency
Currency Swaps
Swaps
 Risks of
Risks of Interest Rate and
Interest Rate and Currency
CurrencySwaps
Swaps
 Is the
Is the Swap
Swap Market
Market Efficient?
Efficient?
 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.
Size of the Swap Market
 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
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.
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.
 The convention is to quote against U.S. dollar LIBOR.
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 3.82–3.85
5.13 means 1.50
5.17 the swap
1.58bank4.11
will pay4.13
4 year 3.06 3.09 fixed-rate
5.12 euro payments
5.17 1.73 at 3.82%
1.81 4.25 4.28
5 year 3.23 3.26 against
5.11 receiving
5.16 euro LIBOR
1.93 2.01 or it will4.39
4.37
6 year 3.38 3.41 receive
5.11 fixed-rate
5.16 euro payments
2.10 2.18 at 4.50
4.46
7 year 3.52 3.55 3.85%
5.10 against
5.15 receiving
2.25 euro LIBOR
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
 Swap Quotations
3.82–3.85 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

€3.85% €3.82% Firm

Firm Swap
B $LIBOR Bank $LIBOR A
While most swaps are quoted against “flat” dollar
LIBOR, “off-market” swaps are available where one
party pays LIBOR plus or minus some number.
Example of an Interest Rate Swap
Consider firms A and Fixed Floating
B; each firm wants to A 5% LIBOR
borrow $40 million for
3 years. 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 5.1—5.2 against dollar LIBOR
for a 3-year swap.
 Example of an Interest Rate Swap

Firm 5.10% Swap

A LIBOR Bank

If Firm A borrows from their bank at 5.0% fixed

and takes up the swap bank on their offer of
5.1—5.2 they can convert their fixed rate 5%
debt into a floating rate debt at LIBOR – 0.10%
Bank A’s all-in-cost:
X = 5.0% + LIBOR – 5.10% = LIBOR – 0.10%
 Example of an Interest Rate Swap

Swap 5.20% Firm

Bank LIBOR B
If Firm B borrows floating from their bank
at LIBOR + 0.20% and takes up the swap
bank on their offer of 5.1—5.2 they can
convert their floating rate debt into a fixed
rate debt at 5.40%
B’s all-in-cost: Bank
= –LIBOR + LIBOR + 0.20% + 5.20% = Y
5.40%
 Example of an Interest Rate Swap

Firm 5.10% Swap 5.20% Firm

A LIBOR Bank LIBOR B

The Swap Bank makes 10 basis points on the deal:

The Swap Bank’s all-in-cost:

= –LIBOR + LIBOR – 5.20% + 5.10% = –0.10%
 Example of an Interest Rate Swap

Firm 5.10% Swap 5.20% Firm

A LIBOR Bank LIBOR B

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. Bank
Bank
Swap Bank earns $40,000 per year. Y
X
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.
Example of an Currency Swap
Firm A is a U.S. MNC and wants to $ €
borrow €40 million for 3 years. A $7% €6%
Firm B is a French MNC and wants B $8% €5%
to borrow $60 million for 3 years
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
Example of a Currency Swap
 Supposethat the Swap Bank publishes these quotes.
The convention is to quote against U.S. dollar LIBOR.

Euro-€ U.S. $
Bid Ask Bid Ask
3 year 5.00 5.20 7.00 7.20

Firm A wants finance euro-

denominated asset in Italy and wants $ €
to borrow euro.
A $7% €6%
A can borrow euro at 6% or they
can borrow euro at 5.2% by using B $8% €5%
a currency swap.
Example of a Currency Swap
(The convention is to quote against U.S. dollar LIBOR.)
$ €
Euro-€ U.S. $
A $7% €6%
Bid Ask Bid Ask
B $8% €5%
5.00 5.20 7.00 7.20
LIBOR
Bank $7.0% Firm $7.0% Swap
X $60m A €5.2% Bank
LIBOR

€40m
$60m
Suppose that Firm A borrows
$60m at $7%; trades for € at
spot.
Firm A then enters in to FOREX Market
2 fixed for floating
Example of a Currency Swap
(The convention is to quote against U.S. dollar LIBOR.)
Euro-€ U.S. $ $ €
Bid Ask Bid Ask A $7% €6%
5.00 5.20 7.00 7.20 B $8% €5%
LIBOR
€40m
Swap $7.2% Firm Bank
Bank €5.0% B €5% Y
LIBOR
$60m
€40m

Suppose that Firm B borrows

€40m at €5%, trades for $.
FOREX Market Firm B then enters in to 2
fixed for floating swaps.
 Example of a Currency Swap
Swap Bank earns 40 bp per year (20bp in $ and 20bp in €).

Firm $7.0% Swap $7.2% Firm

A €5.2% Bank €5.0% B

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.
Bank Bank
Firm B earns 80 bp per year on the swap Y
X and hedges exchange rate risk.
 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.

$ € The QSD is calculated as

A $7% €6% the difference between the
differences.
B $8% €5%
QSD 1% – –1% = 2%
 Comparative Advantage
as the Basis for Swaps
 A has a comparative advantage in borrowing in
dollars.
 B has a comparative advantage in borrowing in
euro.
$ €
A $7% €6%
B $8% €5%
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
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.
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.
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.
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
 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 $8½%
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
Thank You