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Currency and Interest Rate Swaps

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.

Chapter Outline:• Types of Swaps• Size of the Swap Market• The Swap Bank• Interest Rate Swaps• Currency Swaps

10Chapter Ten

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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. Cross Currency Interest Rate Swap (Currency swap)

Fixed for fixed rate debt service in two (or more) currencies.

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.

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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).

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Interest Rate Swap

Each party will issue the less advantageous form of debt.

SwapBank

Company A prefers floating

Company B prefers fixed

Pay fixedPay floating

ReceiveFloating

Receive fixed

Issue floatingIssue fixed

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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.

The borrowing opportunities of the two firms are: COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

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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

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

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

Swap

Bank

LIBOR

10.50%

Bank

A

Issue $10M debtat 10% fixed-rate

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COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

An Example of an Interest Rate Swap

Here’s what’s 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.

10%

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

Swap

Bank

LIBOR

10.50%

Bank

A

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An Example of an Interest Rate Swap

Company

B

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

Bank10.75%

LIBOR

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

Issue $10M debt at LIBOR+0.50% floating-rate

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COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

An Example of an Interest Rate Swap

Firm B can borrow externally at

LIBOR + .50 % and have a net

borrowing position of

10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating (11.75%).

LIBOR + .50%

Here’s what’s in it for Firm B:

0.5 % of $10,000,000 = $50,000 that’s quite a

cost savings per year for 5 years.

Swap

Bank

Company

B

10.75%

LIBOR

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An Example of an Interest Rate Swap

The swap bank makes money too.

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

LIBOR+10.75%– LIBOR-10.50%=0.25%

Swap

Bank

Company

B

10.75%

LIBORLIBOR

10.50%

Bank

A

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

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An Example of an Interest Rate Swap

Swap

Bank

Company

B

10.75%

LIBORLIBOR

10.50%

Bank

A

B saves .50%A saves .50%

The swap bank makes .25%

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% 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 Receive Net

Company A LIBOR 8% -(LIBOR+.25)

Swap Dealer w/A 7.75% LIBOR

Company B 8.25% LIBOR -8.75%

Swap Dealer w/B LIBOR 8.5%

Swap Dealer Net LIBOR+7.75% LIBOR+8.25% +0.50%

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Currency Swaps

Most often used when companies make cross-border 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. Borrow US$ and convert to Euro – exposes company to exchange

rate risk.

2. Borrow in Germany – rate available may not be as good as that in the U.S. if the subsidiary is relatively unknown.

3. 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

issue local issue local

SwapBank

CompanyA

CompanyB

Pay foreign pay foreign

Receivelocal

Receivelocal

Issue local Issue local

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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 Germany–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% 7.0%

Company B 9.0% 6.0%

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$8%

An Example of a Currency Swap

Firm

B

$8% € 6%

Swap

Bank

Firm

A

€ 6%

$8%

€ 6%

$ €

Company A 8.0% 7.0%

Company B 9.0% 6.0%

Borrow$52M

Borrow€ 40M

Annual Interest$4.16M

Annual Interest€2.4 M

Annual Interest$4.16M

Annual Interest€2.4 M

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$8%

An Example of a Currency Swap

Firm

B

$8% € 6%

Swap

Bank

Firm

A

€ 6%

$8%

€ 6%

$ €

Company A 8.0% 7.0%

Company B 9.0% 6.0%

$52M € 40M

A’s net position is to borrow at € 6%

B’s net position is to borrow at $8%

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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 – 3.50Means 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 RiskInterest 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 indicesExchange rate RiskExchange rates might move against the swap bank after it has only gotten half

of a swap set up. Credit RiskThis is the major risk faced by a swap dealer—the risk that a counter party

will default on its end of the swap.Mismatch RiskIt’s hard to find a counterparty that wants to borrow the right amount of

money for the right amount of time.Sovereign RiskThe risk that a country will impose exchange rate restrictions that will

interfere with performance on the swap.