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SWAPS The Short-Term Currency Swap An illustration: Bank of England (BoE) wants to borrow USD from the Bundesbank (Buba). Buba asks, as security, an equivalent amount of GBP (to be deposited by the BoE with the Buba). Barring default, on the expiration day the USD and the GBP would each be returned, with interest, to the respective owners Example S = USD/GBP 2.5, r $ = 3%, r £ = 5%. time t: BoE receives USD 100m from the Buba for six months, deposits GBP 100m/2.5 = GBP 40m into an escrow account with the Buba. time T: the Buba returns GBP 40m ¥ 1.05 = 42m, and the BoE returns USD 100m ¥ 1.03 = USD 103m

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SWAPS Two ways to view the traditional short-time swap contract View 1: two mutual loan contracts, one for USD 100m to the Bank of England, and the other for GBP 40m to the Bundesbank, with a right-of-offset clause linking the two loans. if one party fails to fulfill its obligations, then the other party is exonerated from its normal obligations too, and can sue the defaulting party if any losses occur

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SWAPS Two ways to view the traditional short-time swap contract View 2: a spot sale by the Bundesbank of USD 100m for GBP, combined with a six month forward purchase of USD 103m at 103/42 = 2.45238 = USD/GBP 2.5 ¥ 1.03/1.05 = F.

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SWAPS Why short-term Swaps exist? 1. Safety 2. Reduction of Transaction Costs 3. Tax Avoidance 4. Religious objections against interest 5. Fictitious Transactions

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SWAPS Why short-term Swaps exist? (cont.) 1. Safety: Example Repurchase order (repo): an investor in need of short-term financing sells low-risk assets (like T-bills) to a lender, and buys them back under a short-term forward contract Low-risk loan low bid-ask spread ('haircut')

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SWAPS Why short-term Swaps exist? (cont.) 2. Reduction of transaction costs: If an investor intends to reverse the transaction Example A French investor is optimistic about $ returns on US stocks, but not about the $ itself. She buys spot USD to invest in US stocks, and sells USD forward to hedge the $ risk

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SWAPS Why short-term Swaps exist? (cont.) 3. Tax Avoidance: When capital gains are taxed at a lower rate Example Buy 10 kilos of gold from a bank at the spot price S t = LUF 5m and sell it back (forward) at F t,T = S t (1+r t,T ) = 5.25m This is a disguised deposit of LUF 5m at 5%, but the return is a capital gain

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SWAPS Why short-term Swaps exist? (cont.) 4. Religious objections against interest: Catholic Church, Islam 5. Fictitious transactions: Hide losses by selling assets at inflated prices (and buy them back at similarly inflated forward prices) Hide the ownership of assets by conjuring them away around the reporting date

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SWAPS Back-to-Back and Parallel Loans The right-of-offset was already used in back-to-back and parallel loans Back-to-back loans: UK institutional investor (UKII) wants to invest in US. But investment dollar premium made foreign investments expensive to UK investors. Thus, UKII wants to avoid the spot market at t and T, by setting up a deal with a foreign firm (USCo) that wants to invest in the UK: USCo lends USD to UKII UKII lends GBP to USCo (or its UK subsidiary) Right of offset between these two loan contracts: if (say) UKII cannot pay back, USCo can withhold its payments and sue for the net loss (if any)

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SWAPS Back-to-back loans: (cont.)

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SWAPS Parallel loans: USCo faces capital export controls, cannot export USD to its UK subsidiary UKCo wants to lend to its US subsidiary, but there is a dollar premium Both can avoid the spot market by granting loans to each other (or to each others subsidiary), with a right of offset in the two loan contracts

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SWAPS The 1981 IBM/World Bank Currency Swap: IBM wanted to call its DEM- and CHF debt: the USD had appreciated considerably and the DEM and CHF interest rates had also gone up. But this would be costly: Exchange transaction costs when IBM buys DEM and CHF Call premium: IBM has to pay more than the DEM and CHF face value Issuing costs when IBM issues new USD bonds. Capital gains taxes on realized gain

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SWAPS The 1981 IBM/World Bank Currency Swap:(cont.) The World Bank (WB) wanted to borrow DEM and CHF to lend to its own customers issuing costs on new CHF and DEM bonds Note that IBM wants to withdraw CHF and DEM bonds (at a rather high cost) while WB wants to issue CHF and DEM bonds (also at a cost). To avoid most of these costs, IBM and WB agreed that WB would take over IBMs foreign debt instead

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SWAPS The 1981 IBM/World Bank Currency Swap:(cont.) Specifically, WB borrows USD instead of DEM, CHF. With the proceeds it buys spot CHF and DEM for its loans WB undertakes to deliver to IBM the DEM and CHF necessary to service IBMs old DEM and CHF loans,... while IBM promised to provide the WB with the USD needed to service the WB's (new) USD loan;

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SWAPS The 1981 IBM/World Bank Currency Swap:(cont.) Right of offset between the undertakings Equal initial value principle: the present value of IBM's (USD) payments to the WB is equal to the present value of the (DEM and CHF) inflows received from the WB.

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SWAPS The 1981 IBM/World Bank Currency Swap:(cont.) Example IBMs DEM debt is DEM 10m at 5% maturing within 5 years The current 5-year DEM interest rate is 10% and S t = USD/DEM 0.4 Market value of service payments: (1)DEM 10m ¥ [1 + (.05 -.1) ¥ a(10 %, 5 years)] = DEM 8.105m or 8.105 ¥.4 = USD 3.242m. So the USD loan should also be worth USD 3.242m.

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SWAPS The Fixed-for-Fixed Currency Swap First review the short-term swap: the contract has zero initial value The spot and forward contracts each have zero value because the amounts are exchanged at the going spot and forward rate Also in the mutual loan view, zero initial value holds [example (Buba/BoE): 5% on GBP, 3% on USD, S t =2.5]: PV USD = = USD 100 ; and PV GBP = = GBP 40, or USD 100

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SWAPS The Fixed-for-Fixed Currency Swap (cont.) the rates used for setting the forward rate or, equivalently, for discounting the promised payments are the (near-riskless) short-term interbank rates: default risk is limited by the forward contracts right-of-offset remaining risks are largely eliminated by screening of the customers, and by margins or other pledges

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SWAPS Characteristics of the Modern Currency Swap Definition. Two parties agree to: exchange, at time t, two initially equivalent principals denominated in different currencies return these principals to each other at T pay the normal interest, periodically, to each other on the amounts borrowed

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SWAPS Characteristics of the Modern Currency Swap (cont.) The deal is structured as one single contract, with a right of offset Example Leg 1 (DEM)leg 2 (USD) 18m at 8%10m at 7% (lent)(borrowed) Initial exchange of principals USD 10.0m annual interest paymentsDEM 1.44m payment of principal at TDEM 18.0m

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SWAPS Characteristics of the Modern Currency Swap (cont.) Swap rates The interest payments for each currency are based on the currency's "swap (interest) rate"yields at par for near-riskless bonds with the same maturity as the swap Why riskfree rates? right-of-offset clause; sometimes margin is posted probability f default is small: screening, 'credit trigger' the uncertainty about the banks inflows is the same as the uncertainty about the banks outflow side. Thus, the corrections for (minute) risk virtually cancel out

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SWAPS Characteristics of the Modern Currency Swap (cont.) Zero Initial value The initial exchange of principals is a zero-value transaction because the amounts are initially equivalent. The future interest payments and amortization have equal present values, too Example (2)PV USD = + = USD 10m, (3)PV DEM = + = DEM 18m which implies that the PV in USD is 18m/1.8 = USD 10m

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SWAPS Characteristics of the Modern Currency Swap (cont.) Costs A commission of, say, USD 500 on a USD 1m swap, for each payment to be made. Most often this fee is built into the interest rates, which would raise or lower the quoted rate by a few basis points Sometimes an equivalent up-front fee is asked Example 7-year yields at par are 7.17% on USD and 9.9% on DEM. The swap dealer quotes: USD 7.13% - 7.21% DEM 9.58% - 9.95% If your swap contract is one where you "borrow" DEM and "lend" USD, you pay 9.95% on the DEM, and you receive 7.13% on the USD

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SWAPS Coupon Swaps (Fixed-for-Floating) Characteristics of the Fixed-for-Floating Swap Example An AA Irish company wants to borrow NZD to finance (and partially hedge) its direct investment in New Zealand. Better conditions in London than in Wellington preference for fixed-rate loans, but spread on revolving bank loans is lower than spread on fixed-rate Eurobonds: [LIBOR+1%] vs 19% [= swap rate + 3%]

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SWAPS Coupon Swaps (Fixed-for-Floating) Characteristics of the Fixed-for-Floating Swap (cont.) The company borrows NZD at the (risk-free) swap rate (16%) plus the spread of 1% it can obtain in the "best" market (the floating-rate Eurobank-loan market)

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SWAPS Base Swaps Example: IN: T-bill rate / OUT: Eurodollar (LIBOR) Why? To speculate on the TED spread (For a swap dealer): to hedge two (unrelated) coupon swapsone where IN is LIBOR and OUT is T-bill

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SWAPS Cross-Currency Swaps

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SWAPS Cocktail Swap

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SWAPS Conclusions Swaps allow a company to borrow in the market where it can obtain the lowest spread exchange the risk-free component of the loans service payments for the risk free component of a another loan that is thought to be more suitable

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SWAPS Case. An Interest Rate Swap: Will it work? Basket Corporation Metro BankSushi Bank Fixed Rate Payer 12% Fixed Floating Rate Swap LIBID (-)1/8% Target Rates At least 12 basis points Fixed Reference Rate: - 7 year note - All in cost 12 7 / 8 % = 12.875% Floating Reference Rate: - Commercial - Paper rate + 1/2% fee 93/8 + 1/2% = 9 7 / 8 % BasketBasket BasketBasket Sushi Bank can issue 7-yr Eurobond at 12%

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SWAPS Case. An Interest Rate Swap: Will it work? (cont.) LIBOR (overnight) = 9% Basis Swap 7 days= 9 1 / 8 % 1 month= 9 2 / 8 % 3 months= 9 3 / 8 % 6 months= 95 / 8 % 1 year= 9 7 / 8 % Total Gain/Loss:+ 109.5 basis points - 50.0 basis points for basket+ 59.5 basis points CP + 1/4% Vs. LIBOR

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SWAPS Case. An Interest Rate Swap: Will it work? (cont.) From Sushi Bank: Point of View: Sushi receives reference:11.66% ie 11 2 / 3 % 12% Sushi pays:LIBOR - 1/2% Reference:LIBOR - 1/8% Total Gain to Sushi Bank:1/3 - 1/8% = 1/12% 3/8 - 1/3 = (9-8)/24 = 1/24% 1/3% loss (-) 3/8% gain

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SWAPS Case. An Interest Rate Swap: Will it work? (cont.) Gain to Metro Bank:12 basis points 1. Swap is successful 2. Default Risk of Counter Parties

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