Currency and Interest Rate Swaps: Chapter Ten
Currency and Interest Rate Swaps: Chapter Ten
Currency and Interest Rate Swaps: Chapter Ten
Chapter Objective:
10
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
1
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:
Plain vanilla fixed-for-floating swaps in one currency. Fixed for fixed rate debt service in two (or more) currencies.
Interest rate swaps: US$ 229.2 trillion !! Currency swaps: US$ 10.8 trillion
Pay floating
Receive Floating
Issue fixed
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
6
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
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
Swap Bank
10.75% LIBOR
Company
B
Issue $10M debt at LIBOR+0.50% floating-rate
COMPANY B BANK A 10% LIBOR
10
Bank
LIBOR
10.75%
0.5 % of $10,000,000 = $50,000 thats quite a cost savings per year for 5 years.
Company B
BANK A 10% LIBOR
10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating (11.75%).
COMPANY Fixed rate Floating rate 11.75% LIBOR + .5% B
LIBOR + .50%
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Swap Bank
LIBOR
Bank A
LIBOR+10.75% LIBOR-10.50%=0.25%
Company B
LIBOR + .5%
Bank
10.75%
LIBOR
Pay Company A Swap Dealer w/A Company B Swap Dealer w/B Swap Dealer Net LIBOR 7.75% 8.25% LIBOR LIBOR+7.75%
Net
-(LIBOR+.25)
-8.75%
+0.50%
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Currency Swaps
Most often used when companies make crossborder capital investments or projects.
Ex., U.S. parent company wants to finance a project undertaken by its subsidiary in Germany. Project proceeds would be used to pay interest and principal. Options:
1.
2.
3.
Borrow US$ 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.
15
Currency Swaps
Typically, a company should have a comparative advantage in borrowing locally
Pay foreign
Swap Bank
Receive local Receive local
pay foreign
Issue local
7.0% 6.0%
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Swap Bank
Firm
A
Firm
B
6% Borrow 40M
7.0% 6.0%
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Swap Bank
Firm
A
$ Company A Company B 8.0% 9.0% 7.0% 6.0%
Firm
B
6% 40M
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