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

1. Defining 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. 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 basic management dilemma: the balance between risk and return. Treasury has traditionally been considered a service center (cost center) and is therefore not expected to take positions that incur risk in the expectation of profit (treasury management practices are rarely evaluated as profit centers). Treasury management practices are therefore predominantly conservative, but opportunities to reduce costs or actually earn profits are not to be ignored.
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2. Management of IR risk As in foreign exchange management exposure, the firm needs expectations a directional and/or volatility view on interest rate movements for the effective management of interest rate risk. Fortunately, interest rate movements have historically shown more stability and less volatility than foreign exchange rate movements. Once management has formed expectations about future interest rate levels and movements, it must choose the appropriate implementation timing, location of market, instruments, etc.
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2. Management of IR risk: credit and repricing risk

Credit risk, or roll-over risk, is the possibility that the lender reclassifies a borrowers credit worthiness when renewing a credit (with changes in fees, interest rates, credit line commitments or even denial of credit). Repricing risk is 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.

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2. Management of IR risk: floating rate loan Example: Carlton Corporation has taken out a $10 million three-year, floating-rate loan, with annual interest 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 an internal rate of return of 7.02%. We call this the allin-cost (AIC) of the loan. Some alternatives to manage interest rate risk are:
Refinancing Forward rate agreements Interest rate futures Interest rate swaps
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2. Management of IR risk: forward rate agreement

A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal. Maturities of the contracts are typically 1, 3, 6, 9 and 12 months. Example: Carlton buys an FRA that locks in the first interest payment (due at the end of year 1) at 5% p.a.
If LIBOR rises above 5% at the end of year 1, Carlton receives a payment for the differential interest rates, If LIBOR falls below 5% at the end of year 1, Carlton makes a payment for the differential interest rates.

Due to limited maturities and currencies available, FRAs are not widely used outside the largest industrial economies and currencies. A series of FRAs is an interest rate swap.
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2. Management of IR risk: interest rate futures 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).

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2. Management of IR risk: interest rate futures Each contract is for a three-month period with a notional principal of $1 million. Each percentage point 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, the futures 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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2. Management of IR risk: interest rate futures

Interest rate futures strategies for common exposures: Paying interest on a future date: sell a futures contract and create a short position If rates go up, the futures price falls and the short earns a profit (offsets loss on interest expense) If rates go down, the futures price rises and the short earns a loss Earning interest on a future date: buy a futures contract and create a long position If rates go up, the futures price falls and the short earns a loss If rates go down, the futures price rises and the long earns a profit
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2. Management of IR risk: interest rate swaps 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 may combine elements of both.

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2. Management of IR risk: interest rate swaps The swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment. What is often termed the plain vanilla swap is an agreement between two parties to exchange fixedrate for floating-rate financial obligations. This type of swap forms the largest single financial derivative market in the world.

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2. IR risk: Why interest rate swaps? Suppose ABC Inc holding a floating-rate debt conclude that interest rates are about to rise. The finance manager of ABC may wish to pay fixed and to receive floating interest payments. If XYZ concludes that interest rates will fall. Then XYZ may wish to pay 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.
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Exhibit 14.8 Comparative advantage and structure of a swap

The firms borrow in their relatively advantaged market and swap.

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2. IR risk: Implementation of interest rate swaps

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 the payments 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.)
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3. Example: Carlton swapping to fixed rates. Consider Carltons $10 million 3-year loan at LIBOR+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.
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Interest rate risk: currency swap 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 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).

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4.

Example: Carlton s currency swap Carlton borrows $10m for 3 years at LIBOR+1.5%. Carlton enters into a float-to-fixed swap at 5.75% p.a. Carlton prefers to make its payments in SF, given a natural inflow of SF from sales contracts. Carlton enters into a three-year currency swap to pay 2.01% SF interest and to receive 5.56% fixed dollars. Current spot rate is SF1.50/$. Carltons cash flows are
year 0 receive $10m pay SF15m year 1 $0.556m year 2 $0.556m year 3 $10.556m

SF0.3015m SF0.3015m SF15.301m

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4. Example: Carlton s currency swap 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, the NPV of cash flows under the swap changes.

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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 dollar for 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 AC is: 7i=1,6 SF100*.05/(1+ .055)i + SF100/1+0.55) =SF95.502m

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 AC will 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) - 7i=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 than 11.875% 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 Canada

AC 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) $ interest rate SF interest rate Cash flows value of $-bond value of SF-bond 2.00 8% p.a. 10% p.a. annual interest: At maturity: $0 $0 1.80 7% p.a. 8% p.a. +$1.6m, -SF4m +$20m, -SF40m $20.677m $23.694m

Value of swap $0 -$3.017m Why value changes? stronger sf and relatively large drop in isf
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Carlton: unwinding swaps As with all original loan agreements, it may happen that at some future date the partners to a swap may wish to terminate the agreement before it matures. Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates, then converting the target currency (Swiss francs) back to the home currency (dollars) of the firm.

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5. Counterparty Risk Counterparty risk is the potential risk that the second party to a financial contract will be unable to fulfill its obligations. 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 Finnish export agency, and a multilateral development bank.

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Exhibit 14.12 A Three-way Back-to-Back CrossCurrency Swap

C$300 million

Province of Ontario
(Canada) $260 million Borrows $390 million at US Treasury + 48 basis points $130 million

C$150 million

Finish Export Credit

(Finland) Borrows C$300 million at Canadian Treasury + 47 basis points

Inter-American Development Bank

Borrows C$150 million at Canadian Treasury + 44 basis points

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Case: McDonald s Corporation s British Pound Exposure

How does the cross-currency swap effectively hedge the three primary exposures of McDonalds has relative to its British subsidiary? How does the cross-currency swap hedge the longterm 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 rate and 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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Chapter 14 Appendix: Advanced Topics

An interest rate floor gives the buyer the right to receive the compensating payment (cash settlement) when the reference interest rate falls below the strike rate of the floor.

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Chapter 14 Appendix: Advanced Topics

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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Chapter 14 Appendix: Advanced Topics

The value of a capped interest payment is composed of three different elements (3-year, 3month LIBOR reference rate cap): The actual three-month payment The amount of the cap payment to the cap buyer if the reference rate rises above the cap rate The annualized cost of the cap

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Chapter 14 Appendix: Advanced Topics

Interest rate floors are basically call options on an interest rate, and equivalently, interest rate floors are put options on an interest rate. A floor guarantees the buyer of the floor option a minimum interest rate to be received (rate of return on notional principal invested) for a specified reinvestment 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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Exhibit 14A.2 Profile of an Interest Rate Cap

Interest Rate Payment (%) 7.50 Uncovered interest rate payment

7.00

6.50 The effective cap 6.00 Capped interest rate payment 5.50

5.00

5.50 6.00 6.50 7.00 7.50 8.00 Actual 3-month LIBOR on reset date (%)
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Exhibit 14A.3 Profile of an Interest Rate Floor

German firms effective investment rate (%) 6.50 Uncovered interest earnings 6.00

5.50

The effective floor

5.00

Interest earnings with floor

4.50

4.00

4.50

5.00 5.50 6.00 6.50 7.00 6-month DM LIBOR on reset date (%)
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Chapter 14 Appendix: Advanced Topics

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 premium from the sale of one side to cover in part of in full the premium expense of purchasing the other side of the collar. If the two premiums are equal, the position is often referred to as a zero-premium collar.

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Exhibit 14A.4 Profile of an Interest Rate Collar

Firms interest rate payment (%) 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 0.5 1.5 2.5 3.5 4.5 5.5 Actual market interest rate (%) 6.5
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Uncovered interest rate payment Floor strike rate Cap strike rate

Interest rate floor Interest rate cap

Chapter 14 Appendix: Advanced Topics

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 firms treasurer would typically purchase a payers swaption, giving the treasurer the right to enter a swap in which they pay the fixed rate and receive the floating rate.

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