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Swaps

Swaps. Add a swap to a loan to change loan’s type Plain vanilla interest rate swap – domestic currency denominated but involving different loan structures, fixed vs. floating rate loans Plain deal foreign currency swap – same loan structure, fixed interest rate, but different currencies.

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Swaps

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  1. Swaps • Add a swap to a loan to change loan’s type • Plain vanilla interest rate swap – domestic currency denominated but involving different loan structures, fixed vs. floating rate loans • Plain deal foreign currency swap – same loan structure, fixed interest rate, but different currencies.

  2. Interest Rate Swap • Swap interpretation: investing in one type and financing in another type • Types = fixed versus floating rate • Coy. B, due to higher credit rating, has an absolute advantage in both types

  3. Plain Vanilla Interest Rate Swap • Coy. B has comparative advantage in fixed rate, interest advantage is greater • Coy. A has comparative advantage in floating rate!!, interest disadvantage is less • Coys. A and B, each has a comparative advantage in the type of loan each does not desire • Preconditions of a viable swap

  4. Interest Rate Swap • Page 2 depicts a specific swap • Other swaps are possible: triangular region specified by the 3 inequalities on page 3 • On border of triangle, one party does not gain; on vertex, two parties do not gain • Gain = 65 basis points for all swaps

  5. FX Swap • Canuck Avions de Ligne, Ltée Case • Comparative advantage requirement for a viable swap is satisfied • CAL has comparative advantage in real, Garota has comparative advantage in C$ • But CAL wants C$, Garota wants reais • Add FX swap to financing in one currency; result: financing in the other currency

  6. FX Swap • Interpretation: A portfolio (5-pack) of forward contracts with different maturities • CAL buys real forward to hedge real loan • Garota buys C$ forward to hedge C$ loan • Implied forward rate common to all 5 maturities is BR7.824/C$ vs. spot rate of BR7.366/C$, qualitatively consistent with IRP.

  7. FX Swap Effects • Garota obtains real financing at its prespecified required rate of 15%, this built into swap cash flow calculations • CAL obtains C$ financing at 9.61%, calculated using the Excel’s IRR function • CAL reduces its C$ financing cost by 89 basis points

  8. Viñas de Valdivia, SA • Determine the reference currency (Chilean peso) cost of financing in another currency (U$) via ex-post Uncovered Interest Parity • Technique applies only to purediscount loan arrangement • UIP: (1+ KU$) = (1+10%)(1+a) where KU$ is the Chilean peso cost of U$ financing and a is the annual appreciation of U$

  9. Viñas de Valdivia, SA • Construct sensitivity analysis graph: gauge sensitivity of Chilean peso cost to a • Breakeven value of a is 36.36%, where the peso costs are equalized • At projected a, peso debt is cheaper • Better to borrow at 50% than at 10%!!!! • 10% in U$’s is 65% in Chilean pesos.

  10. Bling-Bling Corporation • Must use IRR function, cannot use ex-post Uncovered Interest Parity, since loan not pure discount arrangement • Complication: issue costs • Issue cost % applies to the gross financing • Gross-up the net financing

  11. Bling-Bling Corporation • Yen cash flows must be forward hedged • FX loan: sell loan proceeds at Bid, buy debt service at Ask • Criterion: Minimize cost of financing in the reference currency (U$) • Technique: determine vector of U$ cash flows, then apply IRR function

  12. Hedging FX financing cash flows • Canuck Avions case: one swap. • Bling-Bling case: five forward contracts • Bling-Bling must buy JY288,659,794 forward for years 1, 2, 3, 4, 5 and JY7,216,494,880 for year 5. • Valid comparison of reference currency vs. FX financing requires that the latter be fully hedged

  13. Principal Repayment Arrangements • 0. Zero-Coupon-type: only 1 debt service date. • 1. Bond-type: pay only interest; at maturity repay entire principal. • 2. Mortgage-type: fully amortized with equal annual debt service (blend of interest and principal repayment). • 3. Type-3: Principal repaid in equal annual installments; debt service declines during loan life. • Ranked from fastest to slowest pace of principal repayment: 3, 2, 1, 0. The higher the number, the faster the pace of principal repayment.

  14. Equal annual repayment of principal (type 3 loan) • Borrow $1 at 10% over two years. • Principal repayment = 0.5 per year. • Interest payments: year1 = $1 x 10% = .1; year2 = $.5 x 10% = .05 • Debt service: year1 = .5 + .1 = .6; year2 = .5 + .05 = .55 • Cash flows: 1; -.6; -.55. IRR = 10%

  15. Tabular format for type 3 loan

  16. Pure discount or zero coupon loan • Net = $100, F = 5%, interest rate = 10%, maturity = 3 years, Gross = $100 / (1-.05) = $105.26 • Debt service occurs at only one point in time, end of year 3 (loan’s maturity) • Debt service = 105.26(1.1)^3 =140.10 • Initial financing reflects Net • Debt service reflects Gross • Cash flows: 100, 0, 0, -140.10 • All-in Cost = 11.9%

  17. Effect of up-front fee on pace of principal repayment to minimize all-in cost • Borrow $1 over 2 years: 10% interest rate, 5% up-front fee • Grossed-up principal = 1.05263 = 1/(1-.05) • Mortgage-type loan: 1; -0.6065; -0.6065 implies cost = 13.9% • Pure-discount bond: 1; 0 ; -1.27368 implies cost = 12.86% • Choose slow pace of principal repayment to amortize up-front loan processing fee over longer effective time horizon (or bond duration). • The faster the pace of principal repayment (other things equal), the higher the all-in cost.

  18. No interest loan! (but loan processing fee charged) • F=5%: need Net=$100, Gross= $105.26 • If pay @ end year 1: Cost = 5.26% since cash flows are 100, -105.26 • If pay @ end year 2: Cost = 2.6% since cash flows are 100, 0, -105.26 • Moral of the story: If incur up-front loan processing fee, choose longest maturity possible.

  19. Effects of loan processing fee (F) and FX-denomination

  20. Financing in FX and incur up-front processing fee • If FX is projected to depreciate or exhibits a forward discount, repay principal slowly, other things equal. Unambiguous: Go slooow bro! • If FX is projected to appreciate or exhibits a forward premium, the two loan facets have contradictory effects. Ambiguous: Dunno bro! • Two loan facets: financing in an FX and incur processing fee up-front.

  21. Covered/Uncovered Interest Parity: Implications • High interest rate currency trades at a forward discount and will depreciate. • Low interest rate currency trades at a forward premium and will appreciate. • The two effects work at cross purposes: one raises, the other lowers the cost of financing in the reference currency. • Implication: Apply Excel’s IRR function!

  22. Dubious Rules of Thumb • Definitions: soft currency, likely to depreciate; hard currency, likely to appreciate. • Always finance in a soft currency. Problem: such a currency exhibits high interest rate. • Always finance in a low interest currency. Problem: such a currency will likely appreciate. Low interest currencies are hard.

  23. Attaching FX Derivatives • An arbitrage play: firm seeking financing must be able to sell the FX derivative at a higher price than that at which it buys the same FX derivative • Financial institutions must face regulatory restrictions which preclude them from direct purchase of the FX derivative • Dual currency or currency option bonds circumvent restrictions

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