1. Swaps 10-1

2. Definitions In a swap, two counterparties agree to a contractual arrangement where in they agree to exchange cash flows at periodic intervals. 2

3. Financial Swaps A financial swap is an agreement between two parties to exchange cash flows according to a formula Financial swaps are derivative securities Currency swaps and interest rate swaps are two types 10-3

4. Currency swaps are mainly used for debt financing in the required currency at a reduced cost due to comparative advantage Interest rate swaps have become important instruments to match maturities of assets and liabilities and also to obtain cost savings 10-4

5. Types of Swaps Interest rate swaps Currency swaps Foreign exchange swaps Non-deliverable currency swaps 10-5

6. There are two types of interest rate swaps: – Single currency interest rate swap Plain vanilla fixed-for-floating swaps are often just called interest rate swaps. – Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies. 6

7. Interest rate swaps It is an agreement between two parties to exchange interest payments on a specific notional principal amount for a specific maturity Notional =theoretical, there is no exchange of principal amount between parties Principal amount is simply taken as reference amount for computing the interest amount 10-7

8. Users-commercial banks, investment banks, insurance companies, government agencies and trusts Interest rate swap helps in hedging interest rate risk Also referred as term structure risk or basis risk 10-8

9. Term structure risk arises on changes in the fixed interest rate term structure E.g. Fixed or floating rate assets are financed – floating or fixed rate liability 10-9

10. Two types- Coupon swaps Basis swaps Coupon Swaps: is an agreement between two parties in which one party agrees to pay other party- Cash flow equal to the interest At a predetermined fixed rate On a notional principal amount for a certain no.of years 10-10

11. Other party pays the counter party cash flows equal to the interest amount At a floating rate On the same notional principal amount for the same period of time 10-11

12. 10-12 Size of the Swap Market In 2005 the notational principal of: interest rate swaps was $12,810,736,000,000(12lakh crore. Currency swaps $1,197,395,000,000(1 lakh crore) The most popular currencies are: – U.S.$ (34%) – ¥ (23%) – DM (11%) – FF (10%) – £ (6%)

13. 10-13 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.

14. 10-14 An Example of an Interest Rate Swap Consider this example of a plain vanilla interest rate swap. Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. – Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. – It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating- rate Eurodollar loans.

15. 10-15 An Example of an Interest Rate Swap Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. – Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. – Alternatively, firm B can raise the money by issuing 5-year FRNs at LIBOR + ½ percent. – Firm B would prefer to borrow at a fixed rate.

16. 10-16 An Example of an Interest Rate Swap The borrowing opportunities of the two firms are shown in the following table:

17. 10-17 The QSD The Quality Spread Differential represents --- the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally.

18. 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. 10-18

19. 10-19 An Example of a Currency Swap Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.

20. – This will give them exchange rate risk: financing a sterling project with dollars. They could borrow pounds in the international bond market, but Pay a lot since they are not as well known abroad. 10-20

21. 10-21 An Example of a Currency Swap If they can find a British MNC with a mirror- image financing need they may both benefit from a swap. If the exchange rate is S 0 ($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

22. 10-22 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 U.K.–based multinational. Both firms wish to finance a project in each others country of the same size. Their borrowing opportunities are given in the table below.

23. 10-23 An Example of a Currency Swap Company A Swap Bank $8% £12% $8% £11% £12% $9.4% Company B

24. 10-24 An Example of a Currency Swap Company A Swap Bank $8% £12% $8% £11% £12% $9.4% Company B As net position is to borrow at £11% A saves £.6%

25. 10-25 An Example of a Currency Swap Company A Swap Bank $8% £12% $8% £11% £12% $9.4% Company B Bs net position is to borrow at $9.4% B saves $.6%

26. 10-26 A is the more credit-worthy of the two firms. Comparative Advantage as the Basis for Swaps A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. A pays 2% less to borrow in dollars than B A pays.4% less to borrow in pounds than B:

27. 10-27 B has a comparative advantage in borrowing in £. Comparative Advantage as the Basis for Swaps B pays 2% more to borrow in dollars than A B pays only.4% more to borrow in pounds than A:

28. 10-28 A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. If they borrow according to their comparative advantage and then swap, there will be gains for both parties. Comparative Advantage as the Basis for Swaps

29. 10-29 Swap Market Quotations They make a market in plain vanilla swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. For example, 6.60 6.85 means the swap bank will pay fixed-rate DM payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate DM payments at 6.85% against receiving dollar LIBOR.

30. 10-30 Variations of Basic Currency and Interest Rate Swaps Currency Swaps – fixed for fixed – fixed for floating – floating for floating – amortizing Interest Rate Swaps – zero-for floating – floating for floating For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

31. 10-31 Risks of Interest Rate and Currency Swaps Interest Rate Risk – Interest rates might move against the swap bank after it has only half of a swap on the books, or if it has an un hedged position. Basis Risk – If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk – In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

32. 10-32 Risks of Interest Rate and Currency Swaps (continued) Credit Risk – This is the major risk faced by a swap dealerthe risk that a counter party will default on its end of the swap. Mismatch Risk – Its 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.

33. 10-33 Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: – Plain vanilla fixed for floating swap gets valued just like a bond. – Currency swap gets valued just like a nest of currency futures.