1. Interest Rate and Currency Swaps
Chapter 14
Interest Rate and Currency Swaps

2. Questions
What are the typical risks faced by MNE related to foreign borrowings?
What are the alternatives to manage those risks?
What is SWAP agreement?
How can SWAP become the alternative to manage borrowing risks?
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3. Interest Rate Risk
All firms – domestic or multinational, small or large, leveraged, or unleveraged – are sensitive to interest rate movements in one way or another.
The single largest interest rate risk of the nonfinancial firm (our focus in this discussion) is debt service; the multicurrency dimension of interest rate risk for the MNE is of serious concern.
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4. Management of Interest Rate Risk
The second most prevalent source of interest rate risk for the MNE lies in its holdings of interest-sensitive securities.
Unlike debt, which is recorded on the right-hand side of the firm’s balance sheet, the marketable securities portfolio of the firm appears on the left-hand side.
Marketable securities represent potential earnings for the firm.
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5. Management of Interest Rate Risk
Before they can manage interest rate risk, treasurers and financial managers of all types must resolve a basic management dilemma: the balance between risk and return.
Treasury has traditionally been considered a service center (cost center) and is therefore not expected to take positions that incur risk in the expectation of profit (treasury management practices are rarely evaluated as profit centers).
Treasury management practices are therefore predominantly conservative, but opportunities to reduce costs or actually earn profits are not to be ignored.
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6. Management of Interest Rate Risk
Both foreign exchange and interest rate risk management must focus on managing existing or anticipated cash flow exposures of the firm.
As in foreign exchange management exposure, the firm cannot undertake informed management or hedging strategies without forming expectations – a directional and/or volatility view – of interest rate movements.
Fortunately, interest rate movements have historically shown more stability and less volatility than foreign exchange rate movements.
Once management has formed expectations about future interest rate levels and movements, it must choose the appropriate implementation, a path that includes the selective use of various techniques and instruments.
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7. Management of Interest Rate Risk
Prior to describing the management of the most common interest rate pricing risks, it is important to distinguish between credit risk and repricing risk.
Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s credit worthiness, at the time of renewing a credit, is reclassified by the lender (resulting in changes to fees, interest rates, credit line commitments or even denial of credit).
Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset.
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8. Management of Interest Rate Risk
As an example, Carlton Corporation has taken out a three-year, floating-rate loan in the amount of US$10 million (annual interest payments).
Some alternatives available to management as a means to manage interest rate risk are as follows:
Refinancing
Forward rate agreements
Interest rate futures
Interest rate swaps
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9. Management of Interest Rate Risk
A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments on a notional principal.
These contracts are settled in cash.
The buyer of an FRA obtains the right to lock in an interest rate for a desired term that begins at a future date.
The contract specifies that the seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate.
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10. Management of Interest Rate Risk
Unlike foreign currency futures, interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial companies.
Their popularity stems from the relatively high liquidity of the interest rate futures markets, their simplicity in use, and the rather standardized interest-rate exposures most firms possess.
The two most widely used futures contracts are the Eurodollar futures traded on the Chicago Mercantile Exchange (CME) and the US Treasury Bond Futures of the Chicago Board of Trade (CBOT).
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11. Management of Interest Rate Risk
Interest rate futures strategies for common exposures:
Paying interest on a future date (sell a futures contract/short position)
If rates go up, the futures price falls and the short earns a profit (offsets loss on interest expense)
If rates go down, the futures price rises and the short earns a loss
Earning interest on a future date (buy a futures contract/long position)
If rates go up, the futures price falls and the short earns a loss
If rates go down, the futures price rises and the long earns a profit
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12. Management of Interest Rate Risk
Swaps are contractual agreements to exchange or swap a series of cash flows.
These cash flows are most commonly the interest payments associated with debt service, such as the floating-rate loan described earlier.
If the agreement is for one party to swap its fixed interest rate payments for the floating interest rate payments of another, it is termed an interest rate swap
If the agreement is to swap currencies of debt service obligation, it is termed a currency swap
A single swap may combine elements of both interest rate and currency swaps
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13. Management of Interest Rate Risk
The swap itself is not a source of capital, but rather an alteration of the cash flows associated with payment.
What is often termed the plain vanilla swap is an agreement between two parties to exchange fixed-rate for floating-rate financial obligations.
This type of swap forms the largest single financial derivative market in the world.
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14. Management of Interest Rate Risk
The two parties may have various motivations for entering into the agreement.
A very common situation is as follows:
A corporate borrower of good credit standing has existing floating-rate debt service payments.
The borrower, may conclude that interest rates are about to rise.
In order to protect the firm against rising debt-service payments, the company’s treasury may enter into a swap agreement to pay fixed/receive floating.
This means the firm will now make fixed interest rate payments and receive from the swap counterparty floating interest rate payments.
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15. Management of Interest Rate Risk
Similarly, a firm with fixed-rate debt that expects interest rates to fall can change fixed-rate debt to floating-rate debt.
In this case, the firm would enter into a pay floating/receive fixed interest rate swap.
Interest rate swaps are also known as coupon swaps.
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16. Exhibit 14.8 Comparative Advantage and Structuring of a Swap Agreement
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17. Management of Interest Rate Risk
Implementation of the Interest Rate Swap:
Unilever borrows at the fixed rate of 7% per annum, and then enters into a receive fixed / pay floating interest rate swap with Citibank.
Unilever agrees in turn to pay Citibank a floating rate of interest; one-year LIBOR.
Xerox borrows at the floating rate of LIBOR plus 3/4%, and then swaps the payments with Citibank. Citibank agrees to service the floating-rate debt payments on behalf of Xerox.
Xerox agrees in turn to pay Citibank a fixed rate of interest, 7.875%, enabling Xerox to make fixed-rate debt service payments – which it prefers – but at a lower cost of funds than it could have acquired on its own.
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18. Carlton Corporation: Swapping to Fixed Rates
Carlton Corporation’s existing floating-rate loan is now the source of some concern.
Recent events have led management to believe that interest rates, specifically LIBOR, may be rising in the three years ahead.
As the loan is relatively new, refinancing is considered too expensive but management believes that a pay fixed/receive floating interest rate swap may be the better alternative for fixing future interest rates now.
This swap agreement does not replace the existing loan agreement; it supplements it.
Note that the swap agreement applies only to the interest payments on the loan and not the principal payments.
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19. Management of Interest Rate Risk
Since all swap rates are derived from the yield curve in each major currency, the fixed- to floating-rate interest rate swap existing in each currency allow firms to swap across currencies.
The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency.
The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated.
Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows (a significant reason for this being cost).
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20. Carlton Corporation: Swapping Floating Dollars into Fixed-Rate Swiss Francs
After raising US$10 million in floating-rate debt, and subsequently swapping into fixed-rate payments, management decides it would prefer to make its payments in Swiss francs.
Since the company has a natural inflow of Swiss francs (sales contract) it may decide to match the currency of its debt denomination to its cash flows with a currency swap.
Carlton now enters into a three-year pay Swiss francs and receive US dollars currency swap.
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21. Carlton Corporation: Swapping Floating Dollars into Fixed-Rate Swiss Francs
The three-year currency swap entered into by Carlton is different from the plain vanilla interest rate swap described in two important ways:
The spot exchange rate in effect on the date of the agreement establishes what the notional principal is in the target currency.
The notional principal itself is part of the swap agreement (because in a currency swap the notional principals are denoted in two currencies, the exchange rate between which is likely to change over the life of the swap).
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22. Carlton Corporation: Unwinding Swaps
As with all original loan agreements, it may happen that at some future date the partners to a swap may wish to terminate the agreement before it matures.
Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates, then converting the target currency (Swiss francs) back to the home currency (US dollars) of the firm.
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23. Counterparty Risk
Counterparty risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract’s specifications.
Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather than over-the-counter derivatives.
Most exchanges, like the Philadelphia Stock Exchange or Chicago Mercantile Exchange are themselves counterparty to all transactions.
The real exposure of an interest or currency swap is not the total notional principal, but the mark-to-market values of differentials in interest of currency interest payments.
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24. Illustrative Case: A Three-Way Back-to-Back Cross-Currency Swap
Individual firms often find special demands for their debt in select markets, allowing them to raise capital at several points lower there than in other markets.
Thus, a growing number of firms are confronted with debt service in currencies that are not normal for their operations.
The result has been a use of debt issuances coupled with swap agreements from inception.
The following exhibit depicts a three-way borrowing plus swap structure between a Canadian province, a Finnish export agency, and a multilateral development bank.
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25. Exhibit 14.12 A Three-way Back-to-Back Cross-Currency Swap
Province of Ontario
(Canada)
C$300
million
C$150
million
$260
million
$130
million
Borrows $390 million
at US Treasury + 48 basis points
Finish Export Credit
(Finland)
Inter-American
Development Bank
Borrows C$300 million
at Canadian Treasury + 47 basis points
Borrows C$150 million
at Canadian Treasury + 44 basis points
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26. Chapter 14 Appendix: Advanced Topics in Interest Rate Management
An interest rate cap is an option to fix a ceiling or maximum short-term interest-rate payment.
The contract is written such that the buyer of the cap will receive a cash payment equal to the difference between the actual market interest rate and the cap strike rate on the notional principal, if the market rate rises above the strike rate.
Like any option, the buyer of the cap pays a premium to the seller of the cap up front for this right.
An interest rate floor gives the buyer the right to receive the compensating payment (cash settlement) when the reference interest rate falls below the strike rate of the floor.
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27. Chapter 14 Appendix: Advanced Topics in Interest Rate Management
No theoretical limit exists to the specification of caps and floors.
Most currency cap markets are liquid for up to ten years in the over-the-counter market, though the majority of trading falls between one and five years.
An added distinction that is important to understanding cap maturity has to do with the number of interest rate resets involved.
A common interest rate cap would be a two-year cap on three-month LIBOR.
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28. Chapter 14 Appendix: Advanced Topics in Interest Rate Management
The value of a capped interest payment is composed of three different elements (3-year, 3-month LIBOR reference rate cap):
The actual three-month payment
The amount of the cap payment to the cap buyer if the reference rate rises above the cap rate
The annualized cost of the cap
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29. Chapter 14 Appendix: Advanced Topics in Interest Rate Management
Interest rate floors are basically call options on an interest rate, and equivalently, interest rate floors are put options on an interest rate.
A floor guarantees the buyer of the floor option a minimum interest rate to be received (rate of return on notional principal invested) for a specified reinvestment period or series of periods.
The pricing and valuation of a floor is the same as that of an interest rate cap.
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30. Exhibit 14A.2 Profile of an Interest Rate Cap
Payment (%)
Actual 3-month LIBOR on reset date (%)
5.00
5.50
6.00
6.50
7.00
7.50
8.00
Uncovered interest
rate payment
Capped interest
The effective “cap”
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31. Exhibit 14A.3 Profile of an Interest Rate Floor
German firm’s effective
investment rate (%)
6-month DM LIBOR on reset date (%)
4.00
4.50
5.00
5.50
6.00
6.50
7.00
Uncovered interest
earnings
Interest earnings
with floor
The effective “floor”
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32. Chapter 14 Appendix: Advanced Topics in Interest Rate Management
An interest rate collar is the simultaneous purchase (sale) of a cap and a sale (purchase) of a floor.
The firm constructing the collar earns a premium from the sale of one side to cover in part of in full the premium expense of purchasing the other side of the collar.
If the two premiums are equal, the position is often referred to as a zero-premium collar.
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33. Exhibit 14A.4 Profile of an Interest Rate Collar
Firm’s interest
rate payment (%)
Actual market interest rate (%)
0.00
2.00
4.00
6.00
8.00
0.5
1.5
3.5
5.5
6.5
4.5
Uncovered interest
rate payment
Interest rate cap
2.5
1.00
3.00
5.00
7.00
9.00
Interest rate floor
Floor strike
rate
Cap strike
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34. Chapter 14 Appendix: Advanced Topics in Interest Rate Management
The purchase of a swap option, a swaption, gives the firm the right but not the obligation to enter into a swap on a pre-determined notional principal at some defined future date at a specified strike rate.
A firm’s treasurer would typically purchase a payer’s swaption, giving the treasurer the right to enter a swap in which they pay the fixed rate and receive the floating rate.
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35. The End See you next week..... !!
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