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Interest Rate and Currency Swaps

Chapter Objective:

Chapter Fourteen

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This chapter discusses currency and interest rate swaps, which are relatively new instruments for p, y hedging long-term interest rate risk and foreign exchange risk.
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Chapter Outline

Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps y p Risks of Interest Rate and Currency Currency Swaps Variations of Basic Interest Rate and Currency Swaps Variations of Basic Interest Rate andSwaps Is the of Interest Rate and Currency Swaps Risks Swap Market Efficient? Is the Swap Market Efficient?
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Definitions

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 Plain vanilla fixed for floating interest rate swaps. This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

Cross-Currency interest rate swap

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Size of the Swap Market

In 2007 the notational principal of:

Interest rate swaps was $271.9 trillion USD. Currency swaps was $12 trillion USD

The most popular currencies are:

U.S. dollar Japanese yen Euro Swiss franc British pound sterling

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Global FX Market Share: By Instruments

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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 broker, h A a b k the swap b k matches counterparties b bank h i 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 Swaps: Basics

Three Parties

A fixed rate payer, who wants to swap to floating rate p y p g A floating rate payer, who wants to swap to fixed rate An intermediary, the Swap Bank, who arranges the swap

Receives floating rate form the fixed rate payer, and takes over the fixed rate payment on his/her behalf Receives fixed rate form the floating rate payer, and takes over the floating rate payment on his/her behalf Receives a fee from both for arranging the deal

The interest payments of the first two parties change The Notional Principle does not change
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The convention is to quote against U.S. dollar LIBOR.

Interest Rate Swap Quotations

Euro-
Bid 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year
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Sterling
Bid 5.21 5.14 Ask 5.22 5.18

Swiss franc
Bid 0.92 1.23 Ask 0.98 1.31

U.S. $
Bid 3.54 3.90 Ask 3.57 3.94

Ask 2.37 2.65 2.89 3.09 3.26 3.41 3.55 3.66 3.77 3.85

2.34 2.62 2.86 3.06 3.23 3.38 3.52 3.63 3.74 3.82

3.823.85 means the swap bank will pay 5.13 5.17 1.50 1.58 4.11 4.13 fixed-rate euro payments at 3.82% 4.28 5.12 5.17 1.73 1.81 4.25 against receiving dollar LIBOR or it will 5.11 5.16 1.93 2.01 4.37 4.39 receive fixed-rate euro 2.18 fi d t payments at 4.50 t 5.11i 5.16 2.10 4.46 t 3.85% against paying dollar LIBOR 4.58 5.10 5.15 2.25 2.33 4.55
5.10 5.09 5.08 5.15 5.14 5.13 2.37 4.48 2.56 2.45 2.56 2.64 4.62 4.70 4.75 4.66 4.72 4.79

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Swap Quotations
3.823.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar t t 3 82% i t i i d ll LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR

Firm B

3.85% $LIBOR

Swap Bank B k

3.82% $LIBOR

Firm A

While most swaps are quoted against flat dollar LIBOR, off-market swaps are available where one party pays LIBOR plus or minus some number.
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Example of an Interest Rate Swap

Consider firms A and B; each firm wants to borrow $40 million for 3 years. years
Fixed A B 5% Floating LIBOR

5.50% LIBOR + .20%

Firm A wants to finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate. A has good credit and can borrow at LIBOR Firm B wants to finance an interest-rate-insensitive asset and therefore wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow at 5.5% The swap bank quotes 5.15.2 against dollar LIBOR for a 3-year swap.
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Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank

If Firm A borrows from their bank at 5.0% fixed p p and takes up the swap bank on their offer of 5.15.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR 0.10%

Bank X
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As all-in-cost: = 5.0% + LIBOR 5.10% = LIBOR 0.10%

Example of an Interest Rate Swap

Swap Bank
5.20%

Firm B LIBOR

If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.15.2 they can convert their floating rate debt into a fixed rate debt at 5.40% Bs all-in-cost: = LIBOR + LIBOR + 0.20% + 5.20% = 5.40%
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Bank Y

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Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank
5.20%

Firm B LIBOR

The Swap Bank makes 10 basis points on the deal: The Swap Banks all-in-cost: = LIBOR + LIBOR 5.20% + 5.10% = 0.10%

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Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank
5.20%

Firm B LIBOR

The notional size is $40 million. The tenor is for 3 years. A earns $40,000 per year on the swap. B earns $40,000 per year on the swap. Swap Bank earns $40,000 per year.

Bank X
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Bank Y

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Using a Swap to Transform a Liability

Firm A has transformed a fixed rate liability into a floater.

A is borrowing at LIBOR .10% A savings of 10 bp

Firm B has transformed a floating rate liability into a fixed rate liability.
B i borrowing at 5.40% is b i 5 40% A savings of 10 bp

The Swap Bank also generates a profit of 10 bp

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The QSD

The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.
Fixed A B QS 5.00% 5.50% 0.50% Floating Libor Libor + 0.20% 0.20% 0.30%

The 0.30% QSD is the difference between the two quality spreads

In this case, the 0.30%, or 30 bp, QSD is equally shared between the two counterparties and the Swap Bank. But there is no reason to presume that the gains will be shared equally.
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What about the Principal?

In our plain vanilla interest-only interest p y rate swap just given, we did not mention swapping the Notational Principal. It could be the case that firm A exchanged principal with their lender (Bank X) and firm B exchanged principal with their outside lender, Bank Y.

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Cash Flows of an Interest-Only Swap: T = 0

Firm A Swap Bank Firm B

Bank X
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Bank Y

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Cash Flows of an Interest-Only Swap: T = 1

Assume LIBOR = 3%

Firm A

$2,040,000 $1,200,000

Swap Bank

$2,080,000

Firm B $1,200,000

Swap Bank earns $40,000 per year. A saves $40,000 per year relative to $40 000 borrowing at LIBOR = 3%.

Bank X
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B saves $40,000 per year relative to borrowing at 5.5%.

Bank Y

Cash Flows of an Interest-Only Swap: T = 2

Assume LIBOR = 4%

Firm A

$2,040,000 $1,600,000

Swap Bank

$2,080,000

Firm B $1,600,000

Swap Bank earns $40,000 per year. A saves $40,000 per year relative to $40 000 borrowing at LIBOR = 4%.

Bank X
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B saves $40,000 per year relative to borrowing at 5.5%.

Bank Y

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Cash Flows of an Interest-Only Swap: T = 3

Assume LIBOR = 5%

Firm A

$2,040,000 $2,000,000

Swap Bank

$2,080,000

Firm B $2,000,000

Swap Bank earns $40,000 per year. A saves $40,000 per year relative to $40 000 borrowing at LIBOR = 4%.

Bank X
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B saves $40,000 per year relative to borrowing at 5.5%.

Bank Y

Currency Swap Agreement

Two counterparties use a Swap Bank to: Convert a liability denominated in one currency into a liability denominated in another currency

Swap principal in the beginning Swap interest during the period Return swapped principle at the end

Equivalent to a series of forward contracts

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Example of an Currency Swap

$ Firm A is a U.S. MNC and wants to borrow 40 million for 3 years. A $7% 6% Firm B is a French MNC and wants to B $8% 5% borrow $60 million for 3 years Firm A wants finance euro denominated asset in Italy and therefore wants to borrow euro.

A can borrow euro at 6% Firm Fi B wants finance a dollar denominated asset and fi d ll d i d d therefore wants to borrow dollars. B can borrow dollars at 8% The current exchange rate is $1.50 = 1.00
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Comparative Advantage as the Basis for Swaps

A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in euro. $
A $7% B $8% 6% 5%

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Example of a Currency Swap

that the Swap Bank publishes these quotes. The convention is to quote against U.S. dollar LIBOR.
Suppose

Euro- Euro Bid Ask 3 year 5.00 5.20

U.S. US $ Bid Ask 7.00 7.20

Firm A wants finance euro-denominated asset in Italy and wants to borrow euro. t i It l d t t b A can borrow euro at 6% or they can borrow euro at 5.2% by using a currency swap.
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$ A $7% B $8%

6% 5%

Example of a Currency Swap

(The convention is to quote against U.S. dollar LIBOR.)

Euro- Bid Ask 5.00 5.20

U.S. $ Bid Ask 7.00 7.20

$ A $7% B $8%

6% 5%

LIBOR

Bank X

$7.0% $60m

Firm A
40m $60m

$7.0% 5.2% LIBOR

Swap Bank

Suppose that Firm A borrows $60m at $7%; trades for at spot.

Firm A then enters in to 2 fixed for floating swaps. 14-25

FOREX Market

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Example of a Currency Swap

(The convention is to quote against U.S. dollar LIBOR.)

Euro- Bid Ask 5.00 5.20 LIBOR

U.S. $ Bid Ask 7.00 7.20

$ A $7% B $8%

6% 5%

Swap Bank

$7.2% 5.0% LIBOR

Firm B
$60m 40m

40m 5%

Bank Y

Suppose that Firm B borrows 40m at 5%, trades for $.

FOREX Market Firm B then enters in to 2

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fixed for floating swaps.

Example of a Currency Swap

Swap Bank earns 40 bp per year (20bp in $ and 20bp in ).

Firm A

$7.0% 5.2%

Swap Bank

$7.2%

Firm B 5.0%

Bank X
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The notional size is $60m for 3 years. Firm A earns 80 bp per year on the swap and hedges exchange rate risk. Firm B earns 80 bp per year on the swap and hedges exchange rate risk. Swap Bank earns 40 bp per year

Bank Y

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Cash Flows of the Swaps: T = 0

Firm A Swap Bank Firm B

Bank X
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Foreign Exchange Spot Market

Bank Y

Cash Flows of the Swaps: T = 1

Assume LIBOR = 3% $1.8m $1.8m

Firm A

$4.2m $4 2 2.08m $1.8m

Swap Bank

$4.32m $4 32 2m $1.8m

Firm B

Bank X
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Swap bank earns 80,000 + $120,000 or .00240m + .002$60m per year. Firm As all-in-cost 2.08m or 5.2% of 40m Firm Bs all-in-cost $4.32 or 7.2% of $60m

Bank Y

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Cash Flows of the Swaps: T = 2

Assume LIBOR = 4% $2.4m $2.4m

Firm A

$4.2m $4 2 2.08m $2.4m

Swap Bank

$4.32m $4 32 2m $2.4m

Firm B

Bank X
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Bank Y

Cash Flows of the Swaps: T = 3

Assume LIBOR = 5% $3m $3m $4.2m $4 2m 2.08m $3m $4.32m $4 32m 2m $3m

Firm A

Swap Bank

Firm B

Bank X
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Bank Y Foreign Exchange Forward Market

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Example of a Direct Currency Swap

If firms A and B knew and trusted each other, they could theoretically cut out the swap bank: $7.0% Firm Firm
$ A $7% B $8% 6% 5%

5.0%

Bank X
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The problem is of course that the swap bank is acting as a broker (or even a dealer) and providing a servicethats why they get paid. Signing 1 contract is less work than 4.

Bank Y

Equivalency of Currency Swap A Debt Service Obligations

$ $7%

6% 5%

B $8%

We can assume that IRP holds between the 5% euro rate and the 7% dollar rate.

This is reasonable since these rates are, respectively, the best rates available for each counterparty who is well known in its national market. ( (1 + i )t According to IRP: Ft = S0 (1 + i$)t
(1.07)1 (1.05)1 F2 = $1.50 (1.07)2 (1.05)2 F3 = $1.50 (1.07)3 (1.05)3

F1 = $1.50

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Swap: A Series of Forward Contracts

0 S0 FX 1.50 IRR CF0 7.00% $60.00 5.00% 40.00 5 00% 40 00 5.00% 40.00 7.00% $60.00
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Year

1 F1 1.5142 CF1 $4.20 2.75 2 75 2.00 $3.06

2 F2 1.5577 CF2 $4.20 2.70 2 70 2.00 $3.12

3 F3 1.5874 CF3 $64.20 40.44 40 44 42.00 $66.67

IRR 7.00% 5.00%

0 $60.00 40.00

1 $4.20 2.75

2 $4.20 2.70

3 $64.20 40.44

p The swap bank could borrow $60m at 7% and use a set of 3 forward contracts to redenominate their bond as a 5% euro bond. 1.00 (1.07) 40m = $60m 2.7477m = $4.20m $1.50 $1.50 (1.05) (1.07)2 2.6963m $4.20m $1.50 2 6963m = $4 20m $1 50 (1.05)2 (1.07)3 40.4446m = $64.20m $1.50 (1.05)3
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IRR 5.00% 7.00%

0 40.00 $60.00

1 2.00 $3.06

2 2.00 $3.12

3 42.00 $66.67

The swap bank could borrow 40m at 5% and use a set of 3 forward contracts to redenominate their bond as a 7% dollar bond. (1.07) $60m = 40m $1.50 $3.06m = 2m $1.50 (1.05) (1.07) (1 07)2 $3.12m = 2m $1.50 (1.05)2
$66.67m = 42m $1.50
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(1.07)3 (1.05)3

Equivalency of Currency Swap Debt Service Obligations

The ability to hedge with covered interest arbitrage is where the swap bank found the 5% and $7% rates Euro- U.S. $
Bid Ask Bid 7.00 Ask 7.20 5.00 5.20

Competition from other swap banks will keep their spreads from getting too widethe theoretical limit is 200 basis points total. (See QSD on next slide.)

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The QSD: Currency Swap

The QSD is calculated as the difference between the spreads in the two countries QSD = 1 (-1) = 2% = 200 bp A & B earn 80 bp each, while Swap Bank earns 40 bp
$ A B QSD 7% 8% 1% 6% 5% 1%

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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. If the floating rates of the two counterparties are not pegged to the same index index. In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Basis Risk

Exchange rate Risk

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Risks of Interest Rate and Currency Swaps (continued)

Credit Risk

This is the major risk faced by a swap dealerthe risk that a counter party will default on its end of the swap. Its hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

Mismatch Risk

Sovereign Risk S i Ri k

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Swap 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 borrowers, well as the swap dealer) through financing that is more suitable for their asset maturity structures.

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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

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Sample Interest Rate Swap Problem

A is a credit-worthy firm

A can borrow at 8% fixed A can borrow at flat LIBOR A prefers to borrow floating B can borrow at 9% fixed B can borrow at LIBOR + % B prefers to borrow fixed

B is a less-credit-worthy firm

Fixed Floating A 8% LIBOR B 9% LIBOR +

Both firms want a 10-year maturity Devise a swap that is mutually beneficial for A and B.

Follow the convention of pricing against flat LIBOR.

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Step 2: We are to quote the swap against flat LIBOR Step 4: check our work Step 3: The QSD = so we have 50 bp to As all-in-cost: distribute among 3 LIBOR 0.2 players. Lets try 20 forLIBOR LIBOR Bs all-in-cost: (Step 2) A and B, (Step 2) 8.8% (this leaves 10 bp Swap Bank Profit Profit: for th f the swap b k) bank) 8.2% 8.3% 10 basis points (Step 3)

Swap Bank

(Step 1)

8%

Outside Lender

Step 1: A is better at borrowing fixed; B is better at borrowing floating so have them borrow externally y according to their comparative advantage
Fixed A 8% B 9%
QSD = 1%

LIBOR +

(Step 1)

Floating LIBOR LIBOR +

% = %

Outside Lender

X
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Sample Currency Swap Problem

A is an Italian firm

A can borrow in euro at 5% fixed A prefers to borrow in dollars but faces 8% cost B can borrow in dollars at 7% B now prefers to borrow in euro but faces 6% cost

B is an American firm

Both firms want a 10-year maturity Devise a feasible swap that eliminates exchange rate risk for A and B

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Step 2: We are to eliminate exchange rate risk for A and B Step 3: The QSD =1.5% so we have 150 bp to distribute among 3 players. Lets try 25 bp 5% for A, 75 bp for B, and (Step 2) 50 b for Swap Bank bp f

Swap $7.5% Bank (Step 2)

(Step 3)

Step 4: check our work As all-in-cost: $7.75%, producing a 25 bp savings Bs all-in-cost: 5.25%, producing a 75 bp savings Swap Bank Profit: 50 basis points

(Step 1)

5%

$7.75% 5.25%
$ A 8% B 7 5% 7.5%

5% 6%

$7.5%

(Step 1)

Outside LenderX

Step 1: A is better at borrowing ; B is better at borrowing $ so have them borrow externally according to their comparative advantage

Outside LenderY

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The First Major Currency Swap: 1981 IBM/World Bank : IBMs Perspective
IBM wanted to call its Deutsche Mark (DEM) and Swiss Franc (CHF) debt: the USD had appreciated considerably and the DM and SF interest rates had also gone up. Due to a depreciation of the DM and Swiss franc against the dollar IBM could realize dollar, a large foreign exchange gain, but only if it could eliminate its DEM and CHF liabilities and lock in the gain. But this would be costly: Exchange transaction costs when IBM buys DEM and CHF Call premium: IBM has to pay more than the DEM and CHF face value Issuing costs when IBM issues new USD bonds. Capital gains taxes on realized gain

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The First Major Currency Swap: 1981 IBM/World Bank: World Banks Perspective
The World Bank (WB) wanted to borrow DEM and CHF to lend to its customers. Though it wanted to lend in DM and Swiss francs, the bank was concerned that saturation in the bond markets could make it difficult to borrow more in these two currencies at a favorable rate. The WB was raising most of its funds in DEM (interest rate = 12%) and Swiss francs (interest rate = 8%). It did not want to borrow in USD (interest rate = 17) Note that: IBM wanted to retire CHF and DEM bonds (at a rather high cost) WB wants to issue CHF and DEM bonds (also at a cost). To avoid most of these costs, IBM and WB agreed that WB would take over IBMs foreign debt instead Salmon Brothers arranged the Swap

The Basic Swap Agreement

WB borrows USD instead of DEM, CHF. With the proceeds it buys spot CHF and DEM for its loans WB undertakes to deliver to IBM the DEM and CHF necessary to service IBMs old DEM and CHF loans, IBM promised to provide the WB with the USD needed to service the WB's (new) USD loan;

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Overview

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