Chapter 18 Interest Rate Swaps, Currency Swaps

International Finance

2

Interest Rate Risk

• All firms—domestic or multinational, small or large, leveraged, or unleveraged—are sensitive to interest rate movements in one way or another.

• The single largest interest rate risk of the nonfinancial firm (our focus in this discussion) is debt service

– The multicurrency dimension of interest rate risk for the MNE is a complicating concern.

• The second most prevalent source of interest rate risk for the MNE lies in its portfolio holdings of interest-sensitive securities

3

Management of Interest Rate Risk

• Both foreign exchange and interest rate risk management must focus on managing existing or anticipated cash flow exposures of the firm

• As in foreign exchange management exposure, the firm cannot undertake informed management or hedging strategies without forming expectations—a directional and/or volatility view—of interest rate movements

• Once management has formed expectations about future interest rate levels and movements, it must choose the appropriate implementation, a path that includes the selective use of various techniques and instruments

4

Credit and Repricing Risk

• Prior to describing the management of the most common interest rate pricing risks, it is important to distinguish between credit risk and repricing risk

• Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s credit worthiness, at the time of renewing a credit, is reclassified by the lender (resulting in changes to fees, interest rates, credit line commitments or even denial of credit)

• Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset (that is, shifts in the term structure of interest rates)

5

Credit and Repricing Risk

• Example: Consider a firm facing three debt strategies

– Strategy #1: Borrow $1 million for 3 years at a fixed rate

– Strategy #2: Borrow $1 million for 3 years at a floating rate, LIBOR + 2% to be reset annually

– Strategy #3: Borrow $1 million for 1 year at a fixed rate, then renew the credit annually

– Although the lowest cost of funds is always a major criterion, it is not the only one

• Strategy #1 assures itself of funding at a known rate for the three years – Sacrifices the ability to enjoy a fall in future interest rates for the security of a fixed rate of

interest should future interest rates rise

• Strategy #2 offers what #1 didn’t, flexibility (and, therefore, repricing risk)– It too assures funding for the three years but offers repricing risk when LIBOR changes– Eliminates credit risk as its spread remains fixed

• Strategy #3 offers more flexibility but more risk; – In the second year the firm faces repricing and credit risk, thus the funds are not guaranteed

for the three years and neither is the price– Also, firm is borrowing on the “short-end” of the yield curve which is typically upward sloping—

hence, the firm likely borrows at a lower rate than in Strategy #1– Volatility, however, is far greater on the short-end than on the long-end of the yield curve

6

Management of Interest Rate Risk

• Example: Carlton Corporation has taken out a three-year, floating-rate loan in the amount of US$10 million (annual interest payments) at LIBOR plus a spread of 1.5%

• Some alternatives available to management as a means to manage interest rate risk are as follows:

– Refinancing

– Forward rate agreements

– Interest rate futures

– Interest rate swaps

Often too expensive

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8

Forward Rate Agreements

• A forward rate agreement (FRA) is an interbank-traded contract to buy or sell an interest rate payment on a notional principal

• These contracts are settled in cash

• The buyer of an FRA obtains the right to lock in an interest rate for a single desired term that begins at a future date

• The contract specifies that

– The seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the agreed rate

– The buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate

• The Bank for International Settlements (BIS) estimates that as of June 30, 2004, the notional amount of FRAs outstanding was $14.4 trillion

9

Forward Rate Agreements

• Example: If Carlton Corporation wishes to lock in a payment, it would buy an FRA which locks in a total interest payment. (Let’s assume the LIBOR curve is flat at 5.00%)

– If LIBOR rises above 5.00%, say to 6.00%,

• Then Carlton would receive a cash payment of 1.00% on $10MM ($100,000) from the FRA seller

• Effectively reducing its LIBOR payment to 5.0% ($600,000-$100,000=$500,000)

– If LIBOR falls below 5.00%, say to 4.00%,

• Then Carlton would pay the FRA seller a cash amount of 1.00% on $10MM

• Effectively increasing its LIBOR payment to 5.00% ($400,000+$100,000=$500,000)

– In both cases, Carlton would still pay 1.5% as a spread for a total of 6.5%

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FYI: Forward Rate Agreements

• The FRA payment actually occurs at the start of the loan period (whereas the interest expense on the underlying loan occurs at the end)

• Therefore, the FRA interest payment is discounted for the number of days in the loan period

• The interest payment on a LIBOR-based FRA is:

360

3601

days

days

LIBOR forward rateInterest payment Notional principal

LIBOR

11

Interest Rate Futures

• Unlike foreign currency futures, interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies.

• Their popularity stems from

– The relatively high liquidity of the interest rate futures markets

– Their simplicity in use

– The rather standardized interest-rate exposures most firms possess

• The two most widely used futures contracts are

– The US Treasury Bond Futures of the Chicago Board of Trade (CBOT)

– The Eurodollar Futures, which trade on:

• Chicago Mercantile Exchange (CME)

• London International Financial Futures Exchange (LIFFE)

• Singapore International Monetary Exchange (SIMEX)

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Interest Rate Futures

• Interest rate futures strategies for common exposures:

– Exposure: Paying floating interest on a future date

– A Solution: sell/short a Treasury bond futures contract

• If rates go up, the futures price falls and the short position earns a profit—that offsets the loss from a greater interest expense

• If rates go down, the futures price rises and the short position earns a loss—that offsets the gain from a lower interest expense

– Exposure: Earning floating interest on a future date

– A Solution: buy/long a Treasury bond futures contract

• If rates go up, the futures price falls and the long earns a loss

• If rates go down, the futures price rises and the long earns a profit

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Interest Rate Futures

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Eurodollar Futures

• 3-month Eurodollar futures contract specifications:

– Notional amount is $1MM

– Variable underlying the contract is the Eurodollar interest rate applicable to a 90-day period beginning on the third Wednesday of the delivery month

• Expressed with quarterly compounding and an actual/360 day convention

– Delivery months of March, June, September, and December up to 10 years

• In addition, short maturity contracts with other delivery months

• When the third Wednesday of the delivery month is reached and the actual interest rate for the following 90-day period is known, the contract is settled in cash

Optional Note: CME and LIFFE conduct their own surveys of banks to determine the LIBOR rate used to determine closing contract prices. Hence, the contracts can settle at slightly different values. SIMEX uses CME’s contract settlement price. In addition, CME and SIMEX have identical contract provisions and allow the contracts on one exchange to be converted into a contract on the other exchange

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Eurodollar Futures

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Eurodollar Futures (FYI)

• If Z is the quoted price for a Eurodollar futures contract, the contract price is:

• For example, a quote of 94.32 corresponds to a contract price of:

• More conveniently, we note that the contract price can be rewritten as:

)](.[,, i25010000001

10,000[100 0.25(100 )]Z

10,000[100 0.25(100 94.32)] $985,800

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Eurodollar Futures (FYI)

• Example: Suppose Our Firm, Inc. has $2MM of floating-rate 90-day LIBOR+1% per annum debt with quarterly compounding and interest payments, and we observe a futures rate of i=5.5% per year.

– How can we use a Eurodollar future to lock in next quarter’s interest rate at 5.5%+1.0%=6.5% per annum?

– Short two 3-month Eurodollar futures contracts!

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FYI: Eurodollar Futures

• Example (cont.):

– Payoff to two future contracts:

– Interest payment on loan:

– Payment on loan net of payoff to future:

)]055.0(25.0)(25.0[000,000,2

)](25.0)(25.0[000,000,2

)](25.01[000,000,1)](25.01[000,000,12

1

01

10

i

ii

ii

])01.0[(000,000,2 36090

1 i

)]065.0(25.0[000,000,2

)]055.0(25.0)(25.0[000,000,2])01.0[(000,000,2 136090

1

ii

Note: we ignore a timing difference. The payoff to the Eurodollar future occurs before the loan quarter and the interest payment is at the end of the quarter

For i0=5.5%

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Swaps

• Swaps are contractual agreements to exchange or swap a series of cash flows

– Whereas a forward rate agreement or currency forward leads to the exchange of cash flows on just one future date, swaps lead to cash flow exchanges on several future dates

• If the agreement is to swap interest payments—say, fixed for a floating—it is termed an interest rate swap

– Most commonly, interest rate swaps are associated with a debt service, such as the floating-rate loan described earlier

– An agreement between two parties to exchange fixed-rate for floating-rate financial obligations is often termed a plain vanilla swap

– This type of swap forms the largest single financial derivative market in the world.

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Swaps

• If the agreement is to swap currencies of debt service it is termed a currency swap

• A single swap may combine elements of both interest rate and currency swap, an interest rate/currency swap

• The outstanding interest rate and currency swaps as of June 30, 2004, totaled US$145.2 trillion according to the Bank of International Settlements (BIS)

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MNEs and Swaps

• Using General Electric (GE) and its subsidiary General Electric Capital Services (GECS) as an example, multinational enterprises (MNEs) use swaps to reduce funding costs and to hedge risk:

– Swaps of interest rates and currencies are used by GE and GECS to optimize funding costs for a particular funding strategy. A cancelable interest rate swap was used by GE to hedge an investment position (1999 Annual Report)

• Eurobonds are usually issued jointly with at least one swap to give the borrower cheaper funds or a more desirable currency

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Interest Rate Swaps

• The most common type of swap is a plain vanilla interest rate swap:

– Company B agrees to pay company A cash flows equal to the interest at a predetermined fixed rate on a notional principal for a number of years

– At the same time, company A agrees to pay company B cash flows equal to interest at a floating rate on the same notational principal

• The cash flows of an interest rate swap are interest rates applied to a set notional or reference amount of capital

• The floating reference rate in many interest rate swap agreements is the London Interbank Offer Rate (LIBOR)

• With interest rate swaps, principal is typically not exchanged, only the future coupon payments on the notional principal

Optional Note: in “basis swaps” the two parties exchange floating interest payments based on different reference rates

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Interest Rate Swaps

• Motivation:

– If a firm with floating-rate debt believes that rates will rise it could enter into a swap agreement to pay fixed and receive floating in order to protect it from rising debt-service payments

– If a firm with fixed-rate debt believes that rates will fall it could enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt-service payments

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Interest Rate Swaps

• Example: A 3-year swap is initiated on March 1, 1999, in which Company B agrees to pay Company A every 6 months an interest rate of 5% per year on a notional principal of $100 MM. In return, Company A agrees to pay Company B every 6 months the 6-month LIBOR rate on the same notional principal.

Company A Company B5.0%

LIBOR

Cash Flows ($MM) to Company B

Date LIBOR (%)

Floating Cash Flow Received

Fixed Cash Flow Paid

Net Cash Flow

March 1, 1999 4.20 September 1, 1999 4.80 +2.10 -2.50 -0.40 March 1, 2000 5.30 +2.40 -2.50 -0.10 September 1, 2000 5.50 +2.65 -2.50 +0.15 March 1, 2001 5.60 +2.75 -2.50 +0.25 September 1, 2001 5.90 +2.80 -2.50 +0.30 March 1, 2002 6.40 +2.95 -2.50 +0.45

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Why Use Interest Rate Swaps?

• To Transform a Liability: In the last example,

– Company B used the swap to transform a $100MM LIBOR + 0.8% floating-rate loan into a 5.8% fixed-rate borrowing

– Company A transformed a $100MM 5.2% fixed-rate loan into a LIBOR + 0.2% floating rate borrowing

Company A Company B5.0%

LIBOR5.2% LIBOR + 0.8%

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Why Use Interest Rate Swaps?

• To Transform an Asset: Alternatively, in the last example,

– Company B owned $100MM in bonds that provided 4.7% per year over three years. This time the swap to transformed this fixed-rate asset into a LIBOR – 0.30% floating-rate asset

– Company A had an investment of $100MM that yielded LIBOR – 0.25%. This time the swap transformed this floating-rate asset into a fixed-rate asset earning 4.75% per year

Company A Company B5.0%

LIBORLIBOR – 0.25% 4.7%

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Role of a Financial Intermediary

• Usually, two nonfinancial companies do not get in touch directly to arrange a swap. Each deal with a financial intermediary such as a bank or other financial institution

• Plain vanilla fixed-for-floating swaps on US interest rates are usually structured to that the financial institutions earns 0.03-0.04% per year on a pair of offsetting transactions

• In the last example, for the case of transforming a liability, an intermediated swap might look as follows:

• In this case, the financial institution earns 0.03% on a notional principal of $100MM

Company AFinancialInstitution

Company B5.2% 4.985%

LIBOR

5.015%

LIBORLIBOR + 0.80%

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Why Interest-rate Swaps Exist

• If company A (B) wants a floating- (fixed-) rate loan, why doesn’t it just do it from the start? An explanation commonly put forward is comparative advantage!

• Example: Suppose that two companies, A and B, both wish to borrow $10MM for 5 years and have been offered the following rates:

– The difference between the two fixed rates is greater than the difference between the two floating rates

• Company B has a comparative advantage in floating-rate markets• Company A has a comparative advantage in fixed-rate markets

• In fact, the combined savings for both firms is 1.2% - 0.70% = 0.50%

Fixed Floating Company A 10.0% 6-month LIBOR + 0.3% Company B 11.2% 6-month LIBOR + 1.0%

Difference = 0.7%Difference = 1.2%

If each firm wishes to borrow where it does NOT have a comparative advantage, an opportunity to swap exists!

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Why Interest-rate Swaps Exist

• Example (cont.):

– Company B pays 10.95% per year—a 0.25% savings over what it could borrow directly in the fixed-rate market

– Company A pays LIBOR + 0.05% per year—a 0.25% savings over what it would pay if it went directly to the floating rate markets

– The combined savings for both firms is 1.2% - 0.70% = 0.50% as expected!

Company A Company B9.95%

LIBOR10% LIBOR + 1%

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Carlton Corporation: Swapping to Fixed Rates

• Example: Carlton Corporation swapping to fixed rates

– Carlton Corporation’s existing floating-rate loan is now the source of some concern.

– Recent events have led management to believe that interest rates, specifically LIBOR, may be rising in the three years ahead.

– As the loan is relatively new, refinancing is considered too expensive but management believes that a pay fixed/receive floating interest rate swap may be the better alternative for fixing future interest rates now.

– This swap agreement does not replace the existing loan agreement; it supplements it

– Note that the swap agreement applies only to the interest payments on the loan and not the principal payments

– Carlton is quoted a fixed rate of 5.750% against LIBOR for a three-year swap

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-6.00%

-7.50%

+6.00%

+6.00%

-6.00%

-4.00%

-5.50%

+4.00%

+4.00%

-4.00%

12-32

Currency Swaps

• Currency swaps resemble back-to-back loans except that it does not appear on a firm’s balance sheet

• In a currency swap, a dealer and a firm agree to exchange an equivalent amount of two different currencies for a specified period of time

– Currency swaps can be negotiated for a wide range of maturities

• A typical currency swap requires two firms to borrow funds in the markets and currencies in which they are best known or get the best rates

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Currency Swaps

• For example, a Japanese firm exporting to the US wanted to construct a matching cash flow swap, it would need US dollar denominated debt

• But if the costs were too great, then it could seek out a US firm who exports to Japan and wanted to construct the same swap

• The US firm would borrow in dollars and the Japanese firm would borrow in yen

• The swap-dealer would then construct the swap so that the US firm would end up “paying yen” and “receiving dollars” be “paying dollars” and “receiving yen”

• This is also called a cross-currency swap

12-34

Using a Cross-Currency Swap to Hedge Currency Exposure

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A Currency Swap

• In its simplest form, a currency swap involves exchanging principal and interest payments at a fixed rate in one currency for the same in another

• A currency swap agreement requires that a principal be specified in each of the two currencies

• Unlike a plain vanilla interest rate swap, the principal amounts are exchanged at the beginning and end of the life of a currency swap

• Usually, the principal amounts are chosen to approximately equal in value at the spot exchange rate when the swap is initiated

– Implicitly, a currency swap has a long-dated foreign exchange forward with a forward rate equal to the spot rate at inception

• A fixed- to floating-rate interest rate swap across two currencies is known as an interest rate/currency swap

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Why Use Currency Swaps?

• The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency

• The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated

• Individual firms often find they can raise capital at several points lower in other markets or there are special demands for their debt in select markets

– Therefore, firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows

• Thus, a growing number of firms are confronted with debt service in currencies that are not normal for their operations

• The result has been a use of debt issuances coupled with currency swap agreements from inception

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Why Currency Swaps Exist

• The economic advantage to swaps stems from:

– Lack of market integration across countries leading to a currency-specific comparative advantage:

• Differences in investor perceptions of firm risk and creditworthiness across countries lead to relative cost savings in one currency over another

• Higher investor demand for a firm’s paper in one currency (coupled with a firm’s need to borrow in a second currency)

– Barriers to arbitrage such as legal restrictions on spot and forward exchange rates

– Tax differentials among countries

• Example: A US corporation may want fixed-rate funds in euros to reduce exchange rate risk exposure from European operations. However, the corporation may be relatively unknown in the European financial markets. If a European corporation has the inverse need, a swap then creates a win-win situation for both parties

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Why Currency Swaps Exist

• Example: Suppose the 5-year borrowing fixed-rate costs to US Inc and Aussie Inc in US dollars and Australian dollars are as follows:

– US Inc appears more creditworthy than Aussie Inc because it is offered lower interest rates in both currencies

– Nevertheless, Aussie Inc has a comparative advantage in the AUD market and US Inc has a comparative advantage in the USD market

• Aussie Inc is more familiar to the Australian financial markets

• US Inc is more familiar to the US financial markets

USD AUD US Inc 5.0% 12.6% Aussie Inc 7.0% 13.0%

Difference = 0.4%Difference = 2.0%

If Aussie Inc wants to borrow in the USD market (where it doesn’t have a comparative advantage) and US Inc wants to borrow in the AUD market (where it doesn’t have a comparative advantage), a perfect situation for a currency swap exits!

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Why Currency Swaps Exist

• Example (cont.): Solution: US Inc borrows USD and Aussie Inc borrows AUD and both swap payments through a swap dealer

– For US Inc, the swap transforms the USD interest rate of 5% per year to an AUD interest rate of 11.9% per year—US Inc is 0.7% better off than if had gone directly to the AUD market

– Similarly, for Aussie Inc, the swap transforms an AUD loan at 13% into a USD loan at 6.3%—Aussie Inc is 0.7% per year better off than if it had gone directly to the USD market

– The swap dealer gains 1.3% per year on its USD cash flows and loses 1.1% on its AUD flows

US IncFinancialInstitution

Aussie IncUSD 5.0% USD 5.0%

AUD 11.9%

USD 6.3%

AUD 13.0%AUD 13.0%

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Carlton Corporation: Swapping to Fixed Rate Swiss Francs

• Example: After raising US$10 million in floating-rate debt, and subsequently swapping into fixed-rate payments, Carlton management decides it would prefer to make its payments in Swiss francs because of a new Swiss buyer

– Since the company has a natural inflow of Swiss francs (from the new Swiss buyer) it may decide to match the currency of its debt to that of its cash flows through a currency swap.

– Carlton now enters into a three-year pay-Swiss francs and receive-US dollars currency swap, a fixed-for-fixed currency swap

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Carlton Corporation: Swapping to Fixed Rate Swiss Francs

• Example (cont.):The three-year currency swap entered into by Carlton is different from the plain vanilla interest rate swap described in two important ways:

– The spot exchange rate in effect on the date of the agreement establishes what the notional principal is in the other currency

– The notional principal itself is part of the swap agreement

• In a currency swap, the notional principal is denoted in two currencies and these amounts are exchanged at the beginning and the end of the swap (in the other direction)

• The exchange rate at which this exchange takes place is very likely to change over the life of the swap

• Nevertheless, the amount of each currency exchanged at maturity is equal to the original amount implying an exchange rate equal to the original spot rate

– Hence, swaps include a long-dated forward at the current spot rate!

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Counterparty Risk

• Counterparty risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract

• Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather than over-the-counter derivatives.

– Most exchanges, like the Philadelphia Stock Exchange or Chicago Mercantile Exchange are themselves counterparty to all transactions

– Exchange-traded contracts are more secure that over-the-counter derivatives as the former have margin accounts, are backed by the exchange (and, hence, all its many owners), and have insurance funds to protect all parties

• The real exposure of an interest or currency swap, however, is not the total notional principal, but just the marked-to-market differentials in interest or currency payments

• A default by one party, nevertheless, leaves the remaining party or parties unhedged!

Optional Note: in the event of any nonpayment of principal or interest by one party, the “right of offset” entitles the other party to a comparable nonpayment. Absent this provision, the default of one party does not release the other from contractual payments!

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Swaptions

• The purchase of a swap option, a swaption, gives the firm the right but not the obligation to enter into a swap on a pre-determined notional principal at some defined future date at a specified strike rate

• A firm’s treasurer would typically buy a swaption termed a payer’s swaption, which gives the treasurer the right to enter a swap in which they pay the fixed rate and receive the floating rate

• A receiver’s swaption gives the buyer the right to pay floating interest and receive fixed interest