Week 9

1. Swaps Week 9

2. Introduction • Swaps are arrangements in which one party trades something with another party • These parties are referred to as Counterparties • The swap market is very large, with trillions of dollars outstanding

3. Introduction (cont’d) • If these payments are in different currencies, it is know as a currency swap. • If the payments are determined by a specified interest rate, it is know as an interest rate swap. • There are also commodity swaps & equity swaps

4. A Use of Swaps: The Foreign Exchange Market (FEM) • The FEM Facilitates the transfer of purchasing power denominated in one currency to purchasing power denominated in another currency. • It spans the globe; with prices moving and currency trading every hour of every business day.

5. Types of Currency Markets 1. Spot Market: - immediate transaction – about 40% of the market • Forward Market:-transactions take place at a specified future date – about 9% of the market 3. The other 51% of transactions are: Swap Transactions

6. Why Swap? Swaps can often resemble forward contracts, but there are some differences: • they take the place of multiple forward contracts, and a possible spot transaction, since the contract specifies a series of payments. • Swaps can be used in risk management, as can options, forwards, and futures, and sometimes at a lower cost than a set of forward contracts

7. Origins of Swaps • The first swaps were currency swaps created not to manage risk but rather to circumvent foreign exchange controls. • In the 1970s, Britain was taxing foreign-exchange transactions in an attempt to promote domestic investment. • If a foreign firm needs access to British currency and finds a firm requiring its own currency, they could swap (or exchange loans in their respective countries) and circumvent the taxes on foreign exchange.

8. The Nuts & Bolts of Swap Trading: • Swaps are traded OTC as opposed to via an exchange. • This allows them to be specified to meet the needs of the counterparties. • Kind of like forwards… • Swap specialists can locate the counterparties required. • They make money by charging a slightly higher swap coupon. They earn the spread on the transaction.

9. Some Definitions • Notional principalis used to signify that this cash amount is not exchanged. • If you think of the swap as an exchange of bonds, since each side owes the other a principle, the two cash flows cancel. • plain vanilla interest rate swap • also known as a fixed-for-floating rate swap.

10. Interest Rate Swap • In an interest rate swap, one firm pays a fixed interest rate on a sum of money and receives from some other firm a floating interest rate on the same sum • An agreement between two parties to exchange a series of interest payments, one for another.

11. Interest Rate Swap Example: • Company ABC will pay Company XYZ an amount based on a notional principal of $5 million and a fixed rate of 5.5 percent on four consecutive future dates: March 15, June 15, September 15, and December 15. • Today’s date is December 15th of the prior year. • XYZ will pay on these same dates the 90-day LIBOR which is prevalent at the beginning of each period.

12. Example cont’d: • The payments to the counterparties (who are ABC and XYZ) are made at the same point in time and in the same currency, what is exchanged is the interest differential between the two counterparties.

13. Why would firm ABC enter into this swap? • Suppose it is borrowing presently at a floating rate. • What will adding this swap do to its portfolio? Please post your answer to the class discussion board for participation credit…

14. Foreign Currency Swap • Two firms initially trade one currency for another • Subsequently, the two firms exchange interest payments, one based on a foreign interest rate and the other based on a U.S. interest rate • Finally, the two firms re-exchange the two currencies

15. Currency Swaps • Used to manage exchange rate risk • Allows you to switch the loan and interest payments from one currency into another. • Can be used by firms who have domestic loans but foreign currency receivables. • Use the receivables to meet payments under the swap.

16. Currency Swaps • Example: Reston Technology enters into currency swap with GSI. Reston will pay euros at 4.35% based on NP of €10 million semiannually for two years. GSI will pay dollars at 6.1% based on NP of $9.804 million semiannually for two years. Notional principals will be exchanged. • See Figure 12.6, p. 440 in Chance • Note the relationship between interest rate and currency swaps in Figure 12.7, p. 441 in Chance

17. How Banks use Swaps • The next few slides will give you a pragmatic look at ways banks use swaps.

18. Using Swapsto Hedge Financing Costs • Interest rate swaps can be used to hedge interest rate risk. They enable a firm to exchange fixed rate payments for variable rate payments, or vice versa. • Financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.

19. Risky Company Choice of 10.5% fixed or LIBOR+1% variable Quality Company Choice of 9% fixed or LIBOR+.5% variable Variable Rate Payments at LIBOR+1% Fixed Rate Payments at 9% Investors in Fixed Rate Bonds Issued by Quality Company Investors in Variable Rate Bonds Issued by Risky Company Illustration of An Interest Rate Swap

20. Variable Rate Payments at LIBOR+.5% Risky Company Choice of 10.5% fixed or LIBOR+1% variable Quality Company Choice of 9% fixed or LIBOR+.5% variable Fixed Rate Payments at 9.5% Variable Rate Payments at LIBOR+1% Fixed Rate Payments at 9% Investors in Fixed Rate Bonds Issued by Quality Company Investors in Variable Rate Bonds Issued by Risky Company Illustration of An Interest Rate Swap

21. Using Swapsto Hedge Financing Costs • Currency swaps can be used to hedge exchange rate risk. They enable firms to exchange currencies at periodic intervals. • An alternative method is the parallel (or back-to-back) loan, which represents simultaneous loans provided by two parties with an agreement to repay the loans at a specified point in the future.

22. Marks Received From Ongoing Operations Dollars Received From Ongoing Operations Dollar Payments Mark Payments Mark Payments Miller Company [known within the dollar- denominated market] Beck Company [known within the mark- denominated market] Dollar Payments Mark Payments Dollar Payments Investors in Dollar- denominated Bonds Issued by Miller Investors in Mark- denominated Bonds Issued by Beck Illustration of A Currency Swap

23. Using Swapsto Hedge Financing Costs • Interest rate swaps can be used to hedge interest rate risk. They enable a firm to exchange fixed rate payments for variable rate payments, or vice versa. • Financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.