Currency and Interest Rate Swaps

Chapter Objective:

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Chapter Ten

This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging longterm interest rate risk and foreign exchange risk.

Chapter Outline:
Types of Swaps

Size of the Swap Market The Swap Bank Interest Rate Swaps Currency Swaps
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Swap Market
In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two basic types of swaps:

Single Currency Interest rate swap

Plain vanilla fixed-for-floating swaps in one currency. Fixed for fixed rate debt service in two (or more) currencies.

Cross Currency Interest Rate Swap (Currency swap)

2006 Notional Principal for:

Interest rate swaps: US$ 229.2 trillion !! Currency swaps: US$ 10.8 trillion

The most popular currencies are: US$, Yen, Euro, SF, BP

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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.

Interest Rate Swap

Used by companies and banks that require either fixed or floating-rate debt. Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments. Since principal is in the same currency and the same amount, only interest payments are exchanged (net).

Interest Rate Swap

Each party will issue the less advantageous form of debt. Swap Bank
Receive fixed Pay fixed

Pay floating

Company A prefers floating

Receive Floating

Company B prefers fixed

Issue floating
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Issue fixed

An Example of an Interest Rate Swap

Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M to finance floating-rate Eurodollar loans.

It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %

Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a five-year economic life.

Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 % Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + 0.50 percent. Firm B would prefer to borrow at a fixed rate because it locks in a financing cost.
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B BANK A 10% LIBOR
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The borrowing opportunities of the two firms are:

The Quality Spread Differential

QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank. QSD arises because of a difference in default risk premiums for fixed (usually larger) and floating rate (usually smaller) instruments for parties with different credit ratings There is no reason to presume that the gains will be shared equally, usually the company with the higher credit rating will take more of the QSD. 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.
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An Example of an Interest Rate Swap

Swap
10.50% LIBOR

Bank

The swap bank makes this offer to Bank A: You pay LIBOR per year on $10 million for 5 years and we will pay you 10.50% on $10 million for 5 years

Bank A
COMPANY B BANK A 10% LIBOR

Issue $10M debt at 10% fixed-rate

Fixed rate Floating rate

11.75% LIBOR + .5%

An Example of an Interest Rate Swap

0.50% of $10,000,000 = $50,000. Thats quite a cost savings per year for 5 years.

Swap Bank

10.50% LIBOR

Heres whats in it for Bank A: Bank A can borrow externally at 10% fixed and have a net borrowing position of -10.50% + 10% + LIBOR = LIBOR 0.50% which is 0.50 % better than they can borrow floating without a swap.

Bank
10%

A
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B

BANK A 10% LIBOR

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An Example of an Interest Rate Swap

The swap bank makes this offer to company B: You pay us 10.75% per year on $10 million for 5 years and we will pay you LIBOR per year on $10 million for 5 years.

Swap Bank
10.75% LIBOR

Company
B
Issue $10M debt at LIBOR+0.50% floating-rate
COMPANY B BANK A 10% LIBOR
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Fixed rate Floating rate

11.75% LIBOR + .5%

An Example of an Interest Rate Swap

Swap
Heres whats in it for Firm B: Firm B can borrow externally at LIBOR + .50 % and have a net borrowing position of

Bank
LIBOR

10.75%

0.5 % of $10,000,000 = $50,000 thats quite a cost savings per year for 5 years.

Company B
BANK A 10% LIBOR

10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating (11.75%).
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B

LIBOR + .50%

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An Example of an Interest Rate Swap

The swap bank makes money too.
10.50% LIBOR

Swap Bank
LIBOR

.25% of $10 million = $25,000 per year for 5 years.

10.75%

Bank A
LIBOR+10.75% LIBOR-10.50%=0.25%

Company B

COMPANY Fixed rate Floating rate 11.75%

BANK A 10% LIBOR

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LIBOR + .5%

An Example of an Interest Rate Swap

The swap bank makes .25% Swap
10.50% LIBOR

Bank
10.75%

LIBOR

Bank A A saves .50%

COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B

Company B B saves .50%

BANK A 10% LIBOR
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Example: Interest Rate Swap

Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed) Company B can borrow at 9.5% fixed or LIBOR + .5% (borrows floating) Company A prefers floating and Company B prefers fixed By entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes .5%

Pay Company A Swap Dealer w/A Company B Swap Dealer w/B Swap Dealer Net LIBOR 7.75% 8.25% LIBOR LIBOR+7.75%

Receive 8% LIBOR LIBOR 8.5% LIBOR+8.25%

Net
-(LIBOR+.25)

-8.75%

+0.50%
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Currency Swaps

Most often used when companies make crossborder capital investments or projects.
Ex., U.S. parent company wants to finance a project undertaken by its subsidiary in Germany. Project proceeds would be used to pay interest and principal. Options:
1.

2.

3.

Borrow US$ and convert to Euro exposes company to exchange rate risk. Borrow in Germany rate available may not be as good as that in the U.S. if the subsidiary is relatively unknown. Find a counterparty and set up a currency swap.
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Currency Swaps
Typically, a company should have a comparative advantage in borrowing locally
Pay foreign

Swap Bank
Receive local Receive local

pay foreign

Company A local issue

Company B local issue

Issue local
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Issue local

An Example of a Currency Swap

Suppose a U.S. MNC wants to finance a 40,000,000 expansion of a German plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for euros. This will give them exchange rate risk: financing a euro project with dollars. They could borrow euro in the international bond market, but pay a premium since they are not as well known abroad. If they can find a German MNC with a mirror-image financing need they may both benefit from a swap. If the spot exchange rate is S0($/ ) = $1.30/ , the U.S. firm needs to find a German firm wanting to finance dollar borrowing in the amount of $52,000,000.
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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 Germanybased multinational. Both firms wish to finance a project in each others country of the same size. Their borrowing opportunities are given in the table below.

$ Company A Company B 8.0% 9.0%

7.0% 6.0%
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An Example of a Currency Swap

Annual Interest $4.16M $8% 6% $8% Borrow $52M

Swap Bank

Annual Interest $4.16M $8% 6% Annual Interest 2.4 M

Firm
A

Annual Interest 2.4 M

Firm
B

6% Borrow 40M

$ Company A Company B 8.0% 9.0%

7.0% 6.0%
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An Example of a Currency Swap

As net position is to borrow at 6%
$8% 6% $8% $52M

Swap Bank

Bs net position is to borrow at $8%

$8% 6%

Firm
A
$ Company A Company B 8.0% 9.0% 7.0% 6.0%

Firm
B

6% 40M

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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 and currency swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

Interest Rate Swap Example:

Swap bank terms: USD: 2.50 2.65 Means that the bank is willing to pay fixed-rate 2.50% interest against receiving LIBOR OR bank is willing to receive fixed-rate 2.65% against paying LIBOR.

Currency Swap Example:

Swap bank terms: USD 2.50 2.65 Euro 3.25 3.50 Means that bank is willing to make fixed rate USD payments at 2.5% in return for receiving fixed rate Euro at 3.5% OR the bank is willing to receive fixed-rate USD at 2.65% in return for making fixed-rate Euro payments at 3.25%
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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 Floating rates of the two counterparties being pegged to two different indices Exchange rate Risk Exchange rates might move against the swap bank after it has only gotten half of a swap set up. 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.
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