new swap ppt
TRANSCRIPT
SWAPS
10-1
10-2
Important contents
Types of Swaps Interest Rate Swaps Currency Swaps Variations of Currency and Interest Rate Swaps Risks of Interest Rate and Currency Swaps Concluding Points About Swaps
10-3
Definitions
In a swap, two counterparties agree to exchange or swap cash flows at periodic intervals.
There are two types of swaps: Interest rate swap – an exchange of fixed-rate interest
payments for floating-rate interest payments. Currency swap – an exchange of interest payments in
one currency for interest payments in another currency.
10-4
An Example of an Interest Rate Swap
Washington Mutual has a huge portfolio of fixed-rate mortgages (averaging 13.25%) financed by deposits earning a floating-rate of interest (currently paying LIBOR + 1%). Income – fixed. Obligations – floating.
What is WAMU afraid of?
10-5
An Example of an Interest Rate Swap
Westcoast Finance provides short-term loans to companies throughout the West (currently charging LIBOR + .75%) and is financed by a 30-year fixed-rate bond issue made 4 years ago (paying 11%). Income – floating. Obligations – fixed.
What is Westcoast afraid of?
10-6
LIBOR
11.75%
An Example of an Interest Rate Swap
WAMU
Swap
Bank
The swap bank makes this offer to WAMU: You pay 11.75 % per year on $10 million notional value for 5 years and we will pay you LIBOR on $10 million for 5 years
10-7
LIBOR
11.75%
An Example of an Interest Rate Swap
WAMU
Swap
Bank
They borrow LIBOR + 1% floating and have a net borrowing position of:
13.25% + LIBOR – (11.75% + LIBOR + 1%) = 0.50%
LIBOR+1%
0.50 % of $10,000,000 = $50,000 per year for 5 years.
13.25%
Here’s what’s in it for WAMU:
10-8
11.25%
LIBOR
An Example of an Interest Rate Swap
Swap
Bank
Westcoast
The swap bank makes this offer to Westcoast: You pay us LIBOR per year on $10 million for 5 years and we will pay you 11.25% per year on $10 million for 5 years.
10-9
11.25%
LIBOR
An Example of an Interest Rate Swap
Swap
Bank
WestcoastThey borrow at 11 % and have a net borrowing position of
(LIBOR + .75 + 11.25%) - (LIBOR + 11%) = 1.00%
11%
Here’s what’s in it for Westcoast:
1 % of $10,000,000 = $100,000 per year for 5 years.
LIBOR + .75%
10-10
LIBOR
11.75% 11.25%
LIBOR
An Example of an Interest Rate Swap
WAMU
Swap
Bank
Westcoast
The swap bank makes money too:
0.5% of $10 million = $50,000 per year for 5 years.
(LIBOR – LIBOR) + (11.75% –11.25%) = 0.50%
10-11
The QSD
The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.
There is no reason to presume that the gains will be shared equally.
In the above example, WAMU is less credit-worthy than Westcoast, which is why they got less of the QSD, compensating the swap bank for WAMU’s higher default risk.
10-12
An Example of an Interest Rate Swap
The borrowing opportunities of the two firms are shown in the following table:
WESTCOAST WAMU DIFFERENTIAL
Fixed rate 11.00% 13.25% 2.25%
Floating rate LIBOR + .75% LIBOR + 1.00 .25%
QSD = 2.00%
10-13
An Example of a Currency Swap
Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant.
They could borrow dollars in the U.S. where they are well known and exchange dollars for pounds. This will give them exchange rate risk: How?
They could borrow pounds in the international bond market, but pay a relatively higher rate since they are not as well known abroad.
10-14
An Example of a Currency Swap
If they can find a British MNC with a mirror-image financing need, each firm may benefit from a swap.
If the exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.
10-15
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 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%
10-16
An Example of a Currency Swap
Company A
Swap
Bank
$8% £12%
$8%
£11%£12%
$9.4%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Company
B
10-17
An Example of a Currency Swap
Company A
Swap
Bank
$8% £12%
$8%
£11%£12%
$9.4%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Company
BA’s net position is to borrow at £11%
A saves £.6%
10-18
An Example of a Currency Swap
Company A
Swap
Bank
$8% £12%
$8%
£11%£12%
$9.4%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Company
BB’s net position is to borrow at $9.4%
B saves $.6%
10-19
An Example of a Currency Swap
Company A
Swap
Bank
$8% £12%
$8%
£11%£12%
$9.4%
Company
B
The swap bank makes money too:
At S0($/£) = $1.60/£, that is a gain of $64,000 per year for 5 years.
However, the swap bank faces exchange rate risk. HOW?
But it may be able to lay it off in another swap.
Receives 1.4% of $16m, pays out 1% of £10m
per year for 5 years.
10-20
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.
Comparative Advantage as the Basis for Swaps
10-21
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/Index Risk If the floating rates of the two counterparties are not
pegged to the same index. Exchange rate Risk
In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.
10-22
Risks of Interest Rate 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.
10-23
Concluding 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 For a swap to be possible, a QSD must exist.
Beyond that, creativity is the only limit.