International: Financial Management

INTERNATIONAL
FINANCIAL
MANAGEMENT
Fourth Edition
EUN / RESNICK
14-0 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate &
Currency Swaps 14
Chapter Fourteen
INTERNATIONAL
Chapter Objective: FINANCIAL
MANAGEMENT
This chapter discusses currency and interest rate
swaps, which are relatively new instruments for
Fourth Edition
hedging long-term interest rate risk and foreign
exchange risk. EUN / RESNICK
Chapter Outline
 Types of Swaps
 Size of the Swap Market
 The Swap Bank
 Swap Market Quotations
 Interest Rate Swaps
 Currency Swaps
 Variations of Basic Interest Rate and Currency Swaps
 Risks of Interest Rate and Currency Swaps
 Is the Swap Market Efficient?
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
 “Plainvanilla” fixed-for-floating swaps are often just called
interest rate swaps.
 Cross-Currency interest rate swap
 Thisis often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.
Size of the Swap Market
 In 2004 the notational principal of:
Interest rate swaps was $127,570 billion USD.
Currency swaps was $7,033 billion USD
 The most popular currencies are:
 U.S. dollar
 Japanese yen
 Euro
 Swiss franc
 British pound sterling
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.
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” swaps
and provide quotes for these. Since the swap
banks are dealers for these swaps, there is a bid-
ask spread.
Interest Rate Swap Quotations
Euro-€ £ Sterling Swiss franc U.S. $
Bid Ask Bid Ask Bid Ask Bid Ask
1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57
2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94
3 year 2.86 2.89 3.82–3.85
5.13 means 1.50
5.17 the swap
1.58bank4.11
will pay4.13
4 year 3.06 3.09 fixed-rate
5.12 euro payments
5.17 1.73 at 3.82%
1.81 4.25 4.28
5 year 3.23 3.26 against
5.11 receiving
5.16 euro LIBOR
1.93 2.01 or it will4.39
4.37
6 year 3.38 3.41 receive
5.11 fixed-rate
5.16 euro payments
2.10 2.18 at 4.50
4.46
7 year 3.52 3.55 3.85%
5.10 against
5.15 receiving
2.25 euro LIBOR
2.33 4.55 4.58
8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66
9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72
10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79
An Example of an Interest Rate Swap
 Consider this example of a “plain vanilla” interest
rate swap.
 Bank A is a AAA-rated international bank located
in the U.K. and wishes to raise $10,000,000 to
finance floating-rate Eurodollar loans.
 Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at
10 percent.
 It would make more sense to for the bank to issue floating-rate
notes at LIBOR to finance floating-rate Eurodollar loans.
 Firm B is a BBB-rated U.S. company. It

needs $10,000,000 to finance an investment
with a five-year economic life.
 Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
 Alternatively, firm B can raise the money by issuing 5-
year floating-rate notes at LIBOR + ½ percent.
 Firm B would prefer to borrow at a fixed rate.
The borrowing opportunities of the two firms

are:
Company B Bank A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Swap The swap bank makes

this offer to Bank A: You
Bank pay LIBOR – 1/8 % per
10 3/8%
year on $10 million for 5
LIBOR – 1/8% years and we will pay you
Bank 10 3/8% on $10 million
A for 5 years
COMPANY B BANK A
½% of $10,000,000 = Swap Here’s what’s in it for Bank A:
$50,000. That’s quite They can borrow externally at
a cost savings per year Bank 10% fixed and have a net
for 5 years. 10 3/8% borrowing position of
LIBOR – 1/8% -10 3/8 + 10 + (LIBOR – 1/8) =
Bank LIBOR – ½ % which is ½ %
10% better than they can borrow
A floating without a swap.
COMPANY B BANK A
The swap bank makes Swap
this offer to company B:
You pay us 10½% per Bank
year on $10 million for 5 10 ½%
years and we will pay LIBOR – ¼%

you LIBOR – ¼ % per Company
year on $10 million for 5
B
years.
COMPANY B BANK A
Here’s what’s in it for B: ½ % of $10,000,000 =
Swap $50,000 that’s quite a cost
Bank savings per year for 5
They can borrow externally at 10 ½% years.
LIBOR + ½ % and have a net LIBOR – ¼%
borrowing position of Company LIBOR
+ ½%
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% B
which is ½% better than they can borrow floating.
COMPANY B BANK A
The swap bank makes Swap ¼% of $10 million =
money too. $25,000 per year for
Bank 5 years.
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
A 10 ½ - 10 3/8 = 1/8 B
¼
COMPANY B BANK A
The swap bank makes ¼%
Swap
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
A B
A saves ½% B saves ½%
COMPANY B BANK A
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 for dollars for
pounds.
 This will give them exchange rate risk: financing a
sterling project with dollars.
 They could borrow pounds in the international
bond market, but pay a premium since they are not
as well known abroad.
 If they can find a British MNC with a mirror-
image financing need they may both benefit from
a swap.
 If the spot 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.
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%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
$ £
Company B 10.0% 12.0%
A’s net position is to borrow Swap

at £11%
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
A saves £.6%
$ £
Company B 10.0% 12.0%
B’s net position is to Swap
borrow at $9.4%
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
$ £ B saves $.6%
Company B 10.0% 12.0%
1.4% of $16 million
The swap bank makes Swap financed with 1% of
money too:
Bank £10 million per year
$8% $9.4% for 5 years.
£11% £12%
$8% Firm At S0($/£) = $1.60/£, that Firm £12%
A is a gain of $64,000 per B
year for 5 years.
The swap bank faces
$224,000 $ £ exchange rate risk,
–$160,000 Company A 8.0% 11.6% but maybe they can
$64,000 Company B 10.0% 12.0% lay it off (in another
swap).
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, 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.
Comparative Advantage
as the Basis for Swaps
A is the more credit-worthy of the two firms.
A pays 2% less to borrow in dollars than B
A pays .4% less to borrow in pounds than B:
$ £
Company B 10.0% 12.0%
A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.
B has a comparative advantage in borrowing in £.
B pays 2% more to borrow in dollars than A
$ £
Company B 10.0% 12.0%
B pays only .4% more to borrow in pounds than A:
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.
Variations of Basic Currency and
Interest Rate Swaps
 Currency Swaps
 fixed for fixed
 fixed for floating
 floating for floating
 amortizing
 Interest Rate Swaps
 zero-for floating
 floating for floating
 For a swap to be possible, a QSD must exist.
Beyond that, creativity is the only limit.
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 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.
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.
Pricing a Swap
 A swap is a derivative security so it can be priced
in terms of the underlying assets:
 How to:
 Any swap’s value is the difference in the present values
of the payment streams that are incoming and outgoing.
 Plain vanilla fixed for floating swaps get valued just
like a pair of bonds.
 Currency swap gets valued just like two nests of
currency forward contracts.
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
well as the swap dealer) through financing that is
more suitable for their asset maturity structures.
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
End Chapter Fourteen

International: Financial Management

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 Firm B is a BBB-rated U.S. company. It

The borrowing opportunities of the two firms

Swap The swap bank makes

years and we will pay LIBOR – ¼%

LIBOR – 1/8% LIBOR – ¼%

LIBOR – 1/8% LIBOR – ¼%

A’s net position is to borrow Swap

A has a comparative advantage in borrowing in dollars.

B pays only .4% more to borrow in pounds than A:

If they borrow according to their comparative

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