Currency and Interest Rate Swaps

1. Currency and Interest Rate Swaps 10Chapter Ten • Chapter Objective: • This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk. Chapter Outline: • Types of Swaps • Size of the Swap Market • The Swap Bank • Interest Rate Swaps • Currency Swaps

2. Swap Market • In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. • There are two basic types of swaps: • Single Currency Interest rate swap • “Plain vanilla” fixed-for-floating swaps in one currency. • Cross Currency Interest Rate Swap (Currency swap) • Fixed for fixed rate debt service in two (or more) currencies. • 2006 Notional Principal for: • Interest rate swaps: US$ 229.2 trillion !! • Currency swaps: US$ 10.8 trillion • The most popular currencies are: US$, Yen, Euro, SF, BP

3. 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.

4. Interest Rate Swap • Used by companies and banks that require either fixed or floating-rate debt. • Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments. • Since principal is in the same currency and the same amount, only interest payments are exchanged (net).

5. Interest Rate Swap • Each party will issue the less advantageous form of debt. Swap Bank Pay fixed Pay floating Company A prefers floating Company B prefers fixed Receive Floating Receive fixed Issue floating Issue fixed

6. An Example of an Interest Rate Swap • Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M to finance floating-rate Eurodollar loans. • It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. • Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 % • Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a five-year economic life. • Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 % • Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + 0.50 percent. • Firm B would prefer to borrow at a fixed rate because it locks in a financing cost. The borrowing opportunities of the two firms are:

7. The Quality Spread Differential • QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank. • QSD arises because of a difference in default risk premiums for fixed (usually larger) and floating rate (usually smaller) instruments for parties with different credit ratings • There is no reason to presume that the gains will be shared equally, usually the company with the higher credit rating will take more of the QSD. • 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.

8. 10.50% LIBOR An Example of an Interest Rate Swap Swap Bank The swap bank makes this offer to Bank A: You pay LIBOR per year on $10 million for 5 years and we will pay you 10.50% on $10 million for 5 years Bank A Issue $10M debt at 10% fixed-rate

9. 10.50% LIBOR 10% An Example of an Interest Rate Swap 0.50% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Here’s what’s in it for Bank A: Bank A can borrow externally at 10% fixed and have a net borrowing position of -10.50% + 10% + LIBOR = LIBOR – 0.50% which is 0.50 % better than they can borrow floating without a swap. Swap Bank Bank A

10. 10.75% LIBOR An Example of an Interest Rate Swap Swap Bank The swap bank makes this offer to company B: You pay us 10.75% per year on $10 million for 5 years and we will pay you LIBOR per year on $10 million for 5 years. Company B Issue $10M debt at LIBOR+0.50% floating-rate

11. 10.75% LIBOR An Example of an Interest Rate Swap 0.5 % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank Here’s what’s in it for Firm B: Firm B can borrow externally at LIBOR + .50 % and have a net borrowing position of 10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating (11.75%). Company B LIBOR + .50%

12. 10.50% 10.75% LIBOR LIBOR An Example of an Interest Rate Swap .25% of $10 million = $25,000 per year for 5 years. The swap bank makes money too. Swap Bank Bank A Company B LIBOR+10.75%– LIBOR-10.50%=0.25%

13. 10.50% 10.75% LIBOR LIBOR An Example of an Interest Rate Swap The swap bank makes .25% Swap Bank Bank A Company B A saves .50% B saves .50%

14. Example: Interest Rate Swap • Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed) • Company B can borrow at 9.5% fixed or LIBOR + .5% (borrows floating) • Company A prefers floating and Company B prefers fixed • By entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes .5%

15. Currency Swaps • Most often used when companies make cross-border capital investments or projects. • Ex., U.S. parent company wants to finance a project undertaken by its subsidiary in Germany. Project proceeds would be used to pay interest and principal. • Options: • Borrow US$ and convert to Euro – exposes company to exchange rate risk. • Borrow in Germany – rate available may not be as good as that in the U.S. if the subsidiary is relatively unknown. • Find a counterparty and set up a currency swap.

16. Currency Swaps • Typically, a company should have a comparative advantage in borrowing locally issue local issue local Swap Bank pay foreign Pay foreign Company A Company B Receive local Receive local Issue local Issue local

17. An Example of a Currency Swap • Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a German plant. • They could borrow dollars in the U.S. where they are well known and exchange for dollars for euros. • This will give them exchange rate risk: financing a euro project with dollars. • They could borrow euro in the international bond market, but pay a premium since they are not as well known abroad. • If they can find a German MNC with a mirror-image financing need they may both benefit from a swap. • If the spot exchange rate is S0($/ €) = $1.30/ €, the U.S. firm needs to find a German firm wanting to finance dollar borrowing in the amount of $52,000,000.

18. An Example of a Currency Swap • Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a Germany–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.

19. $8% $8% € 6% € 6% $8% € 6% An Example of a Currency Swap Annual Interest $4.16M Swap Bank Annual Interest $4.16M Firm A Firm B Annual Interest €2.4M Annual Interest €2.4M Borrow $52M Borrow €40M

20. $8% $8% € 6% € 6% $8% € 6% An Example of a Currency Swap A’s net position is to borrow at € 6% B’s net position is to borrow at $8% Swap Bank Firm A Firm B $52M €40M

21. 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” and currency swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. • Interest Rate Swap Example: • Swap bank terms: USD: 2.50 – 2.65 Means that the bank is willing to pay fixed-rate 2.50% interest against receiving LIBOR OR bank is willing to receive fixed-rate 2.65% against paying LIBOR. • Currency Swap Example: • Swap bank terms: USD 2.50 – 2.65 Euro 3.25 – 3.50 Means that bank is willing to make fixed rate USD payments at 2.5% in return for receiving fixed rate Euro at 3.5% OR the bank is willing to receive fixed-rate USD at 2.65% in return for making fixed-rate Euro payments at 3.25%

22. 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 • Floating rates of the two counterparties being pegged to two different indices Exchange rate Risk • Exchange rates might move against the swap bank after it has only gotten half of a swap set up. 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.