part3d swap

8/3/2019 Part3D Swap

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IIID Interest Rate and Currency Swaps

Read ch 14 (pp. 466-485)

1. Defining interest rate risk

2. Management of interest rate risk

3. Example: Carlton interest rate swap

4. Example: Carlton currency swap

5. Counterparty risk

6. Example: A three-way swaps


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1. Defining Interest Rate Risk

All firms domestic or multinational, small or large,

leveraged, or unleveraged are sensitive to interestrate movements in one way or another.

Sources of interest rate risk for a nonfinancial firm:

debt service; the multicurrency dimension of interest

rate risk for the MNE is of serious concern.

holdings of interest-sensitive securities.

A reference rate is the rate of interest used in a

standardized quotation, and loan agreements.LIBOR (London Interbank Offered Rate) is the most

widely used reference rate.


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2. Management of Interest Rate Risk

Before treasurers and financial managers can

manage interest rate risk, they must resolve a basicmanagement dilemma: the balance between riskand return.

Treasury has traditionally been considered a service

center (cost center) and is therefore not expected totake positions that incur risk in the expectation of

profit (treasury management practices are rarelyevaluated as profit centers).

Treasury management practices are thereforepredominantly conservative, but opportunities toreduce costs or actually earn profits are not to beignored.


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2. Management of IR risk

As in foreign exchange management exposure, the

firm needs expectations a directional and/orvolatility view on interest rate movements for the

effective management of interest rate risk.

Fortunately, interest rate movements have historicallyshown more stability and less volatility than foreign

exchange rate movements.

Once management has formed expectations about

future interest rate levels and movements, it mustchoose the appropriate implementation timing,

location of market, instruments, etc.


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Credit risk, orroll-over risk, is the possibility that the

lender reclassifies a borrowers credit worthiness whenrenewing a credit (with changes in fees, interest rates,

credit line commitments or even denial of credit).

Repricing riskis the risk of changes in interest rates at

the time a financial contracts rate is reset. Consider the three choices of $1 million loan:

Three year at a fixed interest rate

Three year at LIBOR+2%, to be reset annually One year at a fixed interest rate, and renew the credit

annually.

2. Management of IR risk: credit and repricingrisk


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Example: Carlton Corporation has taken out a $10

million three-year, floating-rate loan, with annualinterest payments, and 1.5% flat initiation fee

payable upfront.

Assuming 5% p.a. for LIBOR, cash flows are

$9.85m, -$0.65m, -$0.65m, -$10.65m, resulting in aninternal rate of return of 7.02%. We call this the all-in-cost (AIC) of the loan.

Some alternatives to manage interest rate risk are:

Refinancing

Forward rate agreements

Interest rate futures

Interest rate swaps

2. Management of IR risk: floating rate loan


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Aforward rate agreement(FRA) is an interbank-tradedcontract to buy or sell interest rate payments on anotional principal. Maturities of the contracts aretypically 1, 3, 6, 9 and 12 months.

Example: Carlton buys an FRA that locks in the firstinterest payment (due at the end of year 1) at 5% p.a.

If LIBOR rises above 5% at the end of year 1, Carltonreceives a payment for the differential interest rates,

If LIBOR falls below 5% at the end of year 1, Carltonmakes a payment for the differential interest rates.

Due to limited maturities and currencies available, FRAsare not widely used outside the largest industrialeconomies and currencies.

A series of FRAs is an interest rate swap.

2. Management of IR risk: forward rateagreement


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Unlike foreign currency futures, nonfinancial

companies relatively widely use interest rate futures. They are popular due to the relatively high liquidity,

simplicity in use, and the standardized interest-rate

exposures most firms possess.

The two most widely used futures contracts are the

Eurodollar and the US Treasury Bond futures traded

on the Chicago Mercantile Exchange (CME).

2. Management of IR risk: interest ratefutures


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2. Management of IR risk: interest ratefutures Each contract is for a three-month period with a

notional principal of $1 million. Each percentagepoint is worth $2,500 ($1m*0.01*90/360).

Yield = 100.00 settlement price

Suppose Carlton Crop sells a one-year futures

contract at a price of 94.76, or at a yield of 5.24%(100.00 94.76).

If interest rates (yields) rise by the maturity date, thefutures price will fall, and Carlton can close the

position at a profit.The profit will offset the losses on the LIBOR

borrowing due to rising interest rates.

In effect, Carlton can lock in interest rate of 5.24%.


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Interest rate futures strategies for common exposures:

Paying interest on a future date: sell a futures contractand create a short position

If rates go up, the futures price falls and the short earnsa profit (offsets loss on interest expense)

If rates go down, the futures price rises and the shortearns a loss

Earning interest on a future date: buy a futures contractand create a long position

If rates go up, the futures price falls and the short earnsa loss

If rates go down, the futures price rises and the longearns a profit

2. Management of IR risk: interest ratefutures


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Swaps are contractual agreements to exchange or

swap a series of cash flows. These cash flows are most commonly the interest

payments associated with debt service.

interest rate swap: Exchange fixed interest rate payments

for the floating interest rate payments.

currency swap: Exchange currencies of debt service

obligation (e.g. from SF loan to $ loan).

interest rate and currency swap: A single swap maycombine elements of both.

2. Management of IR risk: interest rateswaps


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The swap itself is not a source of capital, but rather

an alteration of the cash flows associated withpayment.

What is often termed theplain vanilla swap is an

agreement between two parties to exchange fixed-

rate for floating-rate financial obligations.

This type of swap forms the largest single financial

derivative market in the world.

2. Management of IR risk: interest rateswaps


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Suppose ABC Inc holding a floating-rate debt

conclude that interest rates are about to rise. The finance manager of ABC may wish topay fixed

and to receive floating interest payments.

If XYZ concludes that interest rates will fall. Then

XYZ may wish topay floating and to receive fixed

interest payments on their fixed-rate debt.

There is an incentive for the two parties to enter into

an interest rate swap.

Interest rate swap exploits a mispricing in two

markets.

2. IR risk: Why interest rate swaps?


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Exhibit 14.8 Comparative advantage and structure ofa swap

The firms borrow in their relatively advantaged market and swap.


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Unilever borrows at 7% p.a., and then enters into

interest rate swap with Citibank.

Unilever agrees to pay Citibank a floating rate of

interest and to receive one-year LIBOR.

Xerox borrows at LIBOR+3/4%, and then swaps thepayments with Citibank.

Xerox agrees to pay Citibank 7.875% p.a. interest

and to receive LIBOR+3/4%.

Net borrowing cost are:

LIBOR for Unilever (saving of % p.a.)

7.875% p.a. for Xerox (saving of 1/8% p.a.)

2. IR risk: Implementation of interest rateswaps


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Consider Carltons $10 million 3-year loan atLIBOR+1.5%. Suppose management believes that

the LIBOR may be rising.

Alternatives:

refinancing: too expensive

interest rate forward: management is not familiar with it.

interest rate swap

Carlton enters into a float-to-fixed swap.

Carlton receives LIBOR and pays 5.75% p.a.

All-in-cost of the loan is 7.25% (5.75%+1.5% spread).Note that the swap agreement applies only to the interest

payments on the loan and not the principal payments.

3. Example: Carlton swapping to fixedrates.


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The usual motivation for a currency swap is to

replace cash flows scheduled in an undesiredcurrency with flows in a desired currency.

The desired currency is probably the currency in

which the firms future operating revenues

(inflows) will be generated.

Firms often raise capital in currencies in which they

do not possess significant revenues or other natural

cash flows (a significant reason for this being cost).

Interest rate risk: currency swap


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Carlton borrows $10m for 3 years at LIBOR+1.5%.

Carlton enters into a float-to-fixed swap at 5.75% p.a.

Carlton prefers to make its payments in SF, given a naturalinflow of SF from sales contracts.

Carlton enters into a three-year currency swap topay 2.01%

SF interest and to receive 5.56% fixed dollars. Current spotrate is SF1.50/$. Carltons cash flows are

4. Example: Carltons currency swap

year 0 year 1 year 2 year 3

receive $10m $0.556m $0.556m $10.556mpay SF15m SF0.3015m SF0.3015m SF15.301m


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The Carltons three-year currency swap is different

from the plain vanilla interest rate swap:The spot exchange rate on the date of the agreement

establishes the notional principal amount in SF.

The notional principal itself is part of the swap

agreement.

On the date of the agreement, the NPV of cash

flows to the two parties of the swap is zero.

As spot rate changes over the life of the swap, theNPV of cash flows under the swap changes.

4. Example: Carltons currency swap


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A detailed look at a currency swap

SCC, a Swiss Co, will issue a SF debt to swap SF for

dollar if it can get $-funds below 11.875% p.a..Principal = SF 100 m. 6 year maturity

Coupon = 5% p.a. Floatation costs = 2.25% flat fee.

Air Canada(AC)will issue a $-bond and swap dollarfor SF if it can get SF-funds at a rate of 5.5% p.a.

PV of the SF debt at 5.5% p.a. to ACis:

i=1,6

SF100*.05/(1+ .055)i + SF100/1+0.55)

=SF95.502m


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ACwill pay $-equivalent of SF97.502m to SCC:

SF 97.502 * ($.50/SF) = $48.751m Assume a floatation cost of 2.125% flat, AC must

issue a $49.809m bond so that

$49.809*(1 - .02125) = $48.751m net proceeds. Dollar bond issue by Air Canada:

Principal = $49.809 m, 6 year maturity

Coupon = 11.25% p.a., Floatation costs = 2.125%


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PV of debt plus swap to SCC:

[SF100*(1 - .0225) - SF97.502]*spot rate

+ $49.809*(1 - .02125)

- i=1,6 $49.809*0.1125/(1+ )j - $49.809/ (1 + ) 6

The IRR on this cash flow is = 11.70% p.a., so the

SCC, the Swiss firm, obtains funds at less than11.875% p.a.


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Value of a swap

Air Canada issues $ debt and swaps into SF debt.

The swap is like:(1) purchasing $ bond (since it will receive $

interest and principal), and

(2) selling SF bond (since it must pay SF interest

and principal)

So, value of swap to Air Canada is:

Value of $ bond - Value of SF bond.


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Example: Value of swap to Air CanadaAC issues a 5-year $20 m bond with 8% p.a. coupon and

swaps into a 5-year SF 40 m debt with 10% p.a. coupon.

Today Year 1

spot rate (SF/S) 2.00 1.80

$ interest rate 8% p.a. 7% p.a.

SF interest rate 10% p.a. 8% p.a.Cash flows annual interest:

At maturity:

+$1.6m, -SF4m

+$20m, -SF40m

value of $-bond $0 $20.677m

value of SF-bond $0 $23.694m

Value of swap $0 -$3.017m

Why value changes? stronger sf and relatively large drop in isf


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As with all original loan agreements, it may happen

that at some future date the partners to a swap maywish to terminate the agreement before it matures.

Unwindinga currency swap requires the

discounting of the remaining cash flows under theswap agreement at current interest rates, then

converting the target currency (Swiss francs) back

to the home currency (dollars) of the firm.

Carlton: unwinding swaps


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5. Counterparty Risk

Counterparty riskis the potential risk that the second

party to a financial contract will be unable to fulfill itsobligations.

Counterparty risk has long been one of the major

factors that favor the use of exchange-traded rather

than over-the-counter derivatives.

The real exposure of a swap is not the total notional

principal, but the mark-to-market values of

differentials in interest or currency interest payments. This differential is similar to the change in swap

value, and typically about 2-3% of the notional

principal.


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Example: A three-way back-to-back cross-currency swap Individual firms often find special demands for their debt in

select markets, allowing them to raise capital at several

points lower there than in other markets.

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

swap agreements from inception.

The following exhibit depicts a three-way borrowing plus

swap structure between a Canadian province, a Finnishexport agency, and a multilateral development bank.


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Finish Export Credit(Finland)

Province of Ontario(Canada)

Inter-American

Development Bank

Borrows $390 million

at US Treasury + 48 basis points

$260

million

$130

million

Borrows C$300 million

at Canadian Treasury + 47 basis points

Borrows C$150 million

at Canadian Treasury + 44 basis points

C$300

million

C$150

million

Exhibit 14.12 A Three-way Back-to-BackCross-Currency Swap


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Case: McDonalds Corporations British PoundExposure

How does the cross-currency swap effectively

hedge the three primary exposures of McDonaldshas relative to its British subsidiary?

How does the cross-currency swap hedge the long-

term equity exposure in the foreign subsidiary?

Should Anka and McDonalds worry about

OCI?


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Chapter 14 Appendix: Advanced Topics

An interest rate cap is an option to fix a ceiling or

maximum short-term interest-rate payment.

The contract is written such that the buyer of the

cap will receive a cash payment equal to the

difference between the actual market interest rateand the cap strike rate on the notional principal, if

the market rate rises above the strike rate.

Like any option, the buyer of the cap pays a

premium to the seller of the cap up front for this

right.


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An interest rate floorgives the buyer the right

to receive the compensating payment (cashsettlement) when the reference interest rate falls

below the strike rate of the floor.



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No theoretical limit exists to the specification of

caps and floors. Most currency cap markets are liquid for up to ten

years in the over-the-counter market, though the

majority of trading falls between one and five

years.

An added distinction that is important to

understanding cap maturity has to do with the

number of interest rate resets involved. A common interest rate cap would be a two-year

cap on three-month LIBOR.



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The value of a capped interest payment is

composed of three different elements (3-year, 3-

month LIBOR reference rate cap):

The actual three-month payment

The amount of the cap payment to the cap buyerif the reference rate rises above the cap rate

The annualized cost of the cap



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Interest rate floors are basically call options on an

interest rate, and equivalently, interest rate floors

are put options on an interest rate.

Afloorguarantees the buyer of the floor option a

minimum interest rate to be received (rate of return

on notional principal invested) for a specifiedreinvestment period or series of periods.

The pricing and valuation of a floor is the same as

that of an interest rate cap.



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Interest Rate

Payment (%)

Actual 3-month LIBOR on reset date (%)

5.00

5.50

6.00

6.50

7.00

5.50 6.00 6.50 7.50 8.007.00

7.50

Uncovered interest

rate payment

Capped interest

rate payment

The effective cap

Exhibit 14A.2 Profile of an Interest Rate Cap


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German firms effective

investment rate (%)

6-month DM LIBOR on reset date (%)

4.00

4.50

5.00

5.50

6.00

4.50 5.00 5.50 6.50 7.006.00

6.50

Uncovered interest

earnings

Interest earnings

with floor

The effective floor

Exhibit 14A.3 Profile of an Interest Rate Floor


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An interest rate collar is the simultaneous purchase

(sale) of a cap and a sale (purchase) of a floor.

The firm constructing the collar earns a premiumfrom the sale of one side to cover in part of in fullthe premium expense of purchasing the other sideof the collar.

If the two premiums are equal, the position is oftenreferred to as azero-premium collar.



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Firms interest

rate payment (%)

Actual market interest rate (%)

0.00

2.00

4.00

6.00

8.00

0.5 1.5 3.5 5.5 6.54.5

Uncovered interest

rate payment

Interest rate cap

2.5

1.00

3.00

5.00

7.00

9.00

Interest rate floor

Floor strike

rate

Cap strike

rate

Exhibit 14A.4 Profile of an Interest Rate Collar


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The purchase of a swap option, aswaption, givesthe firm the right but not the obligation to enter into

a swap on a pre-determined notional principal atsome defined future date at a specified strike rate.

A firms treasurer would typically purchase a

payers swaption, giving the treasurer the right toenter a swap in which they pay the fixed rate andreceive the floating rate.


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