fin 645: international financial management lecture 5 currency & interest rate swaps

FIN 645: International Financial Management

Lecture 5

Currency & Interest Rate Swaps

Lecture OutlineLecture Outline• Types of Swaps• Size of the Swap Market• The Swap Bank• Interest Rate Swaps• Currency Swaps

Lecture Outline (continued)Lecture Outline (continued)• Swap Market Quotations• Variations of Basic Currency and

Interest Rate Swaps• Risks of Interest Rate and Currency

Swaps• Swap Market Efficiency• Concluding Points About Swaps

DefinitionsDefinitions• 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 MarketSize of the Swap Market• In 2007, the total amount of interest rate

swaps outstanding was $ 271.9 trillion($36,262 billion in 1998) and outstanding Currency swaps$12 trillion($2253 billion in 1998)

• The most popular currencies are:– U.S.$ (34%)– ¥ (23%)– € (21%)– £ (6%)

The Swap BankThe 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 in Project Finance Interest Rate Swap in Project Finance TransactionsTransactions

– Definition of Project Finance– Three Approaches to Structured Finance– Types of Interest Rate– What is Interest Rate Risk? – What is Interest Rate Swap?– Types of Swaps– Advantages of Swap– Pricing of an Interest Rate Swap– Other Derivatives Used in Project Finance Transactions


“The raising of funds to finance a stand-alone capital intensive project in which the providers of the funds look primarily to the cash flow from the project as the source of (a) repayment of their loans, and (b) return

on their equity invested in the project”

Definition of Project Finance

Interest Rate Swap in Project Finance TransactionsInterest Rate Swap in Project Finance Transactions

Structured Finance

Project FinanceAcquisition

FinanceSecuritization

Three Approaches to Structured Finance


Types of Interest Rate• Fixed rate

– 10% on a 5-year bond• Floating/variable rate

– LIBOR, certificate of deposit, repo rate, average weighted deposit rate (AWDR) of scheduled banks, call money rate, etc.

What is Interest Rate Risk?

• The uncertainty that over the life of the loan, interest rate may move adversely, thereby, causing a huge interest burden for the project


Important Concepts

• Notional principal (the amount used as the basis for

computations of net payments to be made by swap counter parties)

• Tenor and payment dates

• Fixed leg

• Variable leg

• Day counting convention

• Payment netting

• Counter party: buyer and seller


Day Counting Conventions

Number of days between two payment

dates X Annual interest

rate

X Notional

principal

Number of days in a year 3 types of day counting conventions

are: actual/365 actual/360 30/360


Payment Netting

If fixed rate is lower than floating rate,theresidual goes to fixed rate payer.

If the fixed rate is higher than the floatingrate,the residual goes to floating ratepayer.

FloatingRate

Fixed Rate

It is a market convention that the exchange of interest payments between two parties is executed through payment netting.


Basic Structure

Swap would be based on

notional principal of $100 million

Bank Bank

Fixed Interest Rate

Variable Interest Rate

$ 150 million loan

$ 100 million loan

Party “A" Party “B"

BA: fixed interest rateAB: variable interest rate


An Example

• Party A agrees to pay 8.75% on $100 million to Party B. Party B agrees to make floating rate payments to Party A in return. However, the actual payment will vary with LIBOR.

Year LIBOR Party B Pays Party A (Floating Rate)

Party A Pays Party B (Fixed

Rate)

0 8.5%

1 LIBOR1 = ? LIBOR0 X 1,000,000 =0.085 X 100,000,000

=8,500,000

8,750,000

2 LIBOR2 = ? LIBOR1 X 100,000,000 875,0000

3 LIBOR3 = ? LIBOR2 X 100,000,000 875,0000

4 LIBOR4 = ? LIBOR3 X 100,000,000 8750000

5 N/A LIBOR4 X 100,000,000 8750000

Net paymentmade is $250,00

0


Types of Swaps

– Plain vanilla swaps,– Amortizing swaps,– Accreting swaps,– Roller coaster swaps,– Basis rate swaps, etc.


Types of Swaps: Plain vanilla swaps

– Floating and fixed payments are regular, e.g. every six months

– Term of the swap is a whole number of years, e.g. 1, 2, 3, 10 years

– One party makes fixed rate payments, the other variable rate payments

– Notional principal remains constant throughout the life of the swaps

– The fixed rate remains constant throughout the life of the swaps

– Suitable for loans with Principal repayment at the end of loan life


Types of Swaps: Accreting swaps

• Used when notional principal increases over time• Typical during the construction period


Types of Swaps: Amortizing swaps• Used when a loan has scheduled repayments of principal

over its term, rather than a bullet repayment structure• Notional principal decreases over time

0

5

10

15

20

25

1stSemi

2ndSemi

3rdSemi

4thSemi

5thSemi

6thSemi

Repayment Period

Pri

ncip

al O

uts

tandin

g


Types of Swaps: Roller coaster swaps• Accommodates the characteristics of both amortizing and

accreting swaps• Typical for large infrastructure projects

0

5

10

15

20

25

1stSemi

2ndSemi

3rdSemi

4thSemi

5thSemi

6thSemi

Construction Period Repayment Period

Pri

nci

pal

Outsta

ndin

g


Types of Swaps: Other swaps

Seasonal swap:An interest rate swap in which the principal alternates between zero and the notional amount (which can change or stay constant). The principal amount of the swap is designed to hedge the seasonal borrowing needs of a company.

Off-market swap:In this type of swap, a premium is built into the swap price to fund the purchase of options or to allow for the restructuring of a hedge portfolio. Off-market swaps are generally used to restructure or cancel old swap/hedge deals: essentially, they simulate a refinancing pack-age


Advantages of Swaps• Theory of comparative advantage applies i.e. entity should borrow at a

rate (fixed/floating) in which it has a comparative advantage.• Suppose X and Y are two companies.• X’s borrowing situations (in fixed and floating rate) are as follows:

Bank (Floating) Bond (Fixed)LIBOR + 0.35% UST+0.70%

• Y’s borrowing situations (in fixed and floating rate) are as follows:Bank (Floating) Bond (Fixed)LIBOR + 1.5% UST+3.50%

• X has absolute advantage on both bank (floating) and bond (fixed) loans. • However, Y has comparative advantage on bank (floating) loans. • Note this, for bank loan credit/quality spread of X vs. Y is 1.15%;

while for bond it is 2.8%.• Hence, Y should borrow at floating rate (from Bank) while X should at

fixed rate (from bond market) and swap among themselves and collectively realize total savings of 1.65% (2.8% minus 1.15%), known as quality spread differential.

• However, how this 1.65% will be shared depends on relative bargaining power. In the illustration that follows, we see that X keeps 1.45% while Y retains 0.2%.


Advantages of Swaps…cont’d

• Assuming LIBOR and UST are 6% and 8.5% respectively, Bank (Floating) Bond (Fixed)

X 9.2% (8.5% + 0.7%)Y 7.5%(6% + 1.5%)

Assuming X & Y enter into a swap for a fixed rate of 10.3% (Y pays fixed rate to X in exchange of LIBOR).

• Position of X, therefore is as follows:Pays fixed rate on bond 9.2% p.a.Receives from Y (10.3%)Pays LIBOR to Y 6.0%Total payments 4.9% p.a. Please note it is less than 1.45% of floating rate of LIBOR+0.35%.

• Position of Y, therefore is as follows:Pays variable rate on bank loan 7.5% p.a.Receives from X (6.0%)Pays fixed rate to X 10.3%Total payments 11.8% p.a.Please note it is less than 0.2% of fixed rate of UST+3.5%.

The QSDThe 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.

• Less credit-worthy entity will probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.


Pricing of Swaps…cont’d.

Fixed Leg

8%

PVof

Float-ing

Leg =$20millFloating Leg

PVof

FixedLeg =$18mill Fixed Leg

7% 7% 7% 7%

PVof

Float-ing


PVof

FixedLeg =$22mill

Fixed Leg

9% 9% 9% 9%

PVof

Float-ing


8% 8% 8%PVof

FixedLeg =$20mill

=

Price of the Swap

Fixed Leg

8%

PVof

Float-ing


PVof

FixedLeg =$18mill Fixed Leg

7% 7% 7% 7%

PVof

Float-ing


PVof

FixedLeg =$22mill

Fixed Leg

9% 9% 9% 9%

PVof

Float-ing


8% 8% 8%PVof

FixedLeg =$20mill

=

>

<

Price of the Swap


Pricing of Swaps

Illustration: A $105 million roller coaster swap Loan amount: $105 million variable-rate loan. Tenor: 5 years. Grace period: 21/2 years.

Construction period: 2 years; during when interest on loan is rolled up and capitalized.

Loan drawdown: 4 equal semi-annual drawdowns; first one commencing at financial closing; while the rest three while facility is being constructed.

Repayment profile: 6 level principal; semi-annual. Repayment starts: First repayment commences on six

months after construction completion. Problem: Find an equivalent fixed rate based on the same

notional principal with same drawdown profile.


• Swap Pricing [Shows Calculations]

Pricing of Swaps…cont’d.


Other Derivatives Used in Project Finance Transactions

– Interest rate cap– Interest rate floor– Interest rate collar


Interest Rate Cap

• An interest-rate cap is a derivative that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) exceeds a specified strike rate (the "cap rate").

• Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.

• Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period. If a payment is due on a USD Libor cap, it is calculated as

Class ExerciseClass Exercise• Payments made under a hypothetical

interest rate scenario by a 3-year USD 200MM notional cap linked to 6-month USD Libor with strike rate of 7.5%. Values for the index rate are 6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%.


Interest Rate Cap…an example

For example, a 3-year, USD 200MM notional cap with 6-month Libor as its index rate, struck at 7.5%. The exhibit shows what the cap's payments would be under a hypothetical interest rate scenario.

Payments made under a hypothetical interest rate scenario by a 3-year USD 200MM notional cap linked to 6-month USD Libor with strike rate of 7.5%. Values for the index rate are 6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%. These result in payments of USD 0MM, USD .25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM.


Interest Rate Floor

• Interest rate floors compare to interest rate caps are derivatives that protect the holder from declines in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) falls below a specified strike rate (the "floor rate").

• Floors are purchased for a premium and typically have maturities between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate.

• Each period, the payment is determined by comparing the current level of the index interest rate with the floor rate. If the index rate is below the floor rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period. In US markets, if a payment is due on a USD Libor floor, it is calculated as

An Example of a Currency SwapAn Example of a Currency Swap

• Suppose a U.S. MNC wants to finance expansion of its German Subsidiary, the cost is € 40,000,000

• Current exchange rate is $0.90/€1, • The MNC could borrow $36,000,000 in the

U.S. where they are well known and exchange for dollars for Euro.– By issuing 5-year bonds at 8%– This will give them exchange rate risk: financing

a Euro project with dollars.


• They could borrow € 40,000,000 in the international bond market, but pay a lot since they are not as well known abroad.– The US firm could borrow 5-year fixed interest

rate of 7 percent; The current normal borrowing rate for a well-known firm of equivalent credit worthiness is 6 percent.

• A German MNC of equivalent creditworthiness has a US subsidiary in need of $36,000,000 to finance capital expenditure with an economic life of five years.


• The German parent could raise € 40,000,000 at a fixed interest rate of 6 percent and convert the fund into US dollars to finance the expenditure.– Transaction exposure is created. If Euro appreciates the US

subsidiary might have difficulty to meet the debt service.

• The German parent could also issue Eurodollar bonds (or Yankee bond in the US capital market), say at a fixed rate of 9 percent, as it is not well known.

• A swap bank could arrange a currency swap, instruct each parent firm to raise funds in its national capital market. Then the principal would be exchanged through the swap bank.


• Annually, the German subsidiary would remit to its US parent € 2,400,000 in interest(6 percent of € 40,000,000) to be passed through the swap bank to the German MNC to meet Euro debt Service.

• The US subsidiary would remit to its German parent $2,880,000 in interest(8 percent of $ 36,000,000) to be passed through the swap bank to the US MNC to meet dollar debt Service.

• At the debt retirement date, the subsidiaries would remit the principal sums to their respective parents through the swap bank to pay off the bond issues in the national capital markets.

Benefits of a Currency SwapBenefits of a Currency Swap• At inception, the principal sums are exchanged at the

current exchange rate of $0.90/ € 1= $36,000,000/ € 40,000,000.

• Each year prior to debt retirement, the swap agreement calls for counterparties to exchange $2,880,000 of interest on US dollar debt for € 2,400,000 of interest on Euro debt; this is a contractual exchange rate of $0.8333/ € 1.

• At the maturity date, a final exchange, including the last interest payment and the re-exchange of the principal sum would take place; $38,880,000 for € 42,400,000. The contractual exchange rate at year 5 is thus $0.9170/ € 1.

• Clearly, the swap locks in foreign exchange rates for each counterparty to meet its debt service obligations over the term of the swap.

US Dollar Euro Currency US Dollar Euro Currency Swap Swap

``US capital market

@8%

US MNC

Euro-denominated

Eurobond market7%

8%

Swap Bank

Germancapital market@6%

GermanMNC

EurodollarEurobond market @9%

Original Principal ExchangeDebt ServiceRe-exchange of principal

6%

=

€@6% €@6%

$@8%$@8%

=

Risks of Interest Rate Risks of Interest Rate and Currency Swapsand 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– Exchange rate might move against the swap

bank.

Risks of Interest Rate Risks of Interest Rate and Currency Swaps (continued)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 EfficiencySwap 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.

An Example of a Currency An Example of a Currency SwapSwap

• If they can find a British MNC with a mirror-image financing need they may both benefit from a swap.

• If the exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.


Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational.

Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

$ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%


Company A

Swap

Bank

$8% £12%

$8%

£11%£12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

B


Company A

Swap

Bank

$8% £12%

$8%

£11%£12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

BA’s net position is to borrow at £11%

A saves £.6%


Company A

Swap

Bank

$8% £12%

$8%

£11%£12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

BB’s net position is to borrow at $9.4%

B saves $.6%


Company A

Swap

Bank

$8% £12%

$8%

£11%£12%

$9.4%

$ £


Company B 10.0% 12.0%

Company

B

The swap bank makes money too:

At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.

The swap bank faces exchange rate risk, but maybe they can lay it off in another swap.

1.4% of $16 million financed with 1% of £10

million per year for 5 years.

A is the more credit-worthy of the two firms.

Comparative Advantage Comparative Advantage as the Basis for Swapsas the Basis for Swaps

$ £


Company B 10.0% 12.0%

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.

A pays 2% less to borrow in dollars than B

A pays .4% less to borrow in pounds than B:

B has a comparative advantage in borrowing in £.


$ £


Company B 10.0% 12.0%

B pays 2% more to borrow in dollars than A

B pays only .4% more to borrow in pounds than A:

A has a comparative advantage in borrowing in dollars.B has a comparative advantage in borrowing in pounds.

If they borrow according to their comparative advantage and then swap, there will be gains for both parties.


Swap Market QuotationsSwap 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.

• For example, 6.60 — 6.85 means the swap bank will pay fixed-rate DM payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate DM payments at 6.85% against receiving dollar LIBOR.

Variations of Basic Currency Variations of Basic Currency and Interest Rate Swapsand 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.

Pricing a SwapPricing a Swap• A swap is a derivative security so it

can be priced in terms of the underlying assets:

• How to:– Plain vanilla fixed for floating swap gets

valued just like a bond.– Currency swap gets valued just like a

nest of currency futures.

Concluding RemarksConcluding 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

An Example of an Interest An Example of an Interest Rate SwapRate Swap

• Consider this example of a “plain vanilla” interest rate swap.

• Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.– Bank A is considering issuing 5-year fixed-rate

Eurodollar bonds at 10 percent.– It would make more sense to for the bank to

issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.


• Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.– Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.– Alternatively, firm B can raise the money by

issuing 5-year FRNs at LIBOR + ½ percent.– Firm B would prefer to borrow at a fixed rate.


The borrowing opportunities of the two firms are shown in the following table:

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + .5% LIBOR .5%

QSD = 1.25%

10 3/8%

LIBOR – 1/8%


Bank

A

Swap

Bank

The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10 3/8%

LIBOR – 1/8%


Bank

A

Swap

Bank

Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of

-10 3/8 + 10 + (LIBOR – 1/8) =

LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%

½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years.

LIBOR – ¼%

10 ½%


Swap

Bank

Company

B

The swap bank makes this offer to company B: You pay us 10 ½ % per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

LIBOR – ¼%

10 ½%


Swap

Bank

Company

B


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

They can borrow externally at LIBOR + ½ % and have a net borrowing position of

10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap.

LIBOR + ½%

Here’s what’s in it for B:½ % of $10,000,000 = $50,000 that’s quite a

cost savings per year for 5 years.

LIBOR + ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %


Bank

A

Swap

Bank

Company

B

A saves ½ %

The swap bank makes money too.


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%

¼ % of $10 million = $25,000 per year

for 5 years.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

10 ½ - 10 3/8 = 1/8

¼

LIBOR + ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %


Bank

A

Swap

Bank

Company

B

A saves ½ %

The swap bank makes ¼ %


Fixed rate 11.75% 10% 1.75%


QSD = 1.25%

10%Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD

Mid1 AnswersMid1 Answers1. (a) p72; (b) p101; © p79; (d) p83; (e) p93.2. Borrow £; buy $ spot; invest $; sell $ forward. forward. For a starting sum of £ 10,000 covered interest arbitrage profit $131.25 or £109.375.3. pp 474-481; pp 484-489;article on Law and

Finance, pp490-492.4. p126, Annex 5A.5. Sell Tk. buy ¥; sell ¥ buy £; sell £ buy Tk. For a

starting sum of Tk. 100,000 triangular arbitrage profit Tk. 3834.80.

6. pp109-110

fin 645: international financial management lecture 5 currency & interest rate swaps

Documents

rate fixed rate

rate swaps currency

rate risk

rate swaps risks

rate swaps outstanding

repo rate

money rate

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