2 Currency and interest rate swaps A swap agreement between two parties commits each counterparty to exchange an amount of funds, determined by a formula, at regular intervals, until the swap expiresIn the case of a currency swap, there is an initial exchange of currency and a reverse exchange at maturity
3 Foreign currency swapA currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing.A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency.A “Plain Vanilla” Foreign Currency Swap is when two firms trade fixed-rate interest payments across currencies.
4 “Plain-Vanilla” foreign currency swap Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country…DellSFr
5 “Plain-Vanilla” foreign currency swap Nestle would like to borrow in Dollars to hedge its sales to the U.S...DellNestle$SFrSFr
6 “Plain-Vanilla” foreign currency swap But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms.DellNestle$SFrSFr
7 “Plain-Vanilla” foreign currency swap But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them...DellNestleNestleI-Bank$$SFrSFrSFr
8 “Plain-Vanilla” foreign currency swap …and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans...DellDellDellNestleNestleNestle$SfrI-BankI-Bank$$$SFrSFrSFrSFr
9 “Plain-Vanilla” foreign currency swap …in return for making the payments in the foreign currency that exactly match the other firm’s obligations.DellDellDellNestleNestleNestleSfr$$SfrI-BankI-Bank$$$SFrSFrSFrSFr
10 “Plain-Vanilla” foreign currency swap In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms.DellDellDellNestleNestleNestleSfr$$SfrI-Bank$$$SFrSFr
11 Comparative borrowing advantage Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant.One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty.In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell. Nonetheless, a swap may be mutually advantageous.
12 Origins and underpinnings of the swap market In the early 1980s, the currency swap evolved as a way to simplify and speed the exchange of currency cash flows between counterparties, and quickly gained popularity.the use of a swap lowers the transaction costs.as a new financial product, it was also not covered by any accounting disclosure or security registration requirements.
13 Accidents in risk management Corporate SectorOrganization Year Losses ContractsProcter & Gamble $102 million Interest rate swap(U.S.)Gibson Greetings $20 million Interest rate swapShowa Shell $1.54 billion Foreign exchange(Japan)Metallgesellschaft $1.3 billion Oil futures(Germany)Allied Lyons $265 million Foreign exchange(U.K.) options
14 Accidents in risk management Public AgenciesOrganization Year Losses ContractsState of Wisconsin $95 million Interest rate swapsInvestment Board(U.S.)Orange County $1.7 billion U.S. government(U.S.) securitiesand interest ratederivativesBritish Councils $900 million Interest rate swaps(U.K.)
15 The basic cash flows of a currency swap Firms A and B can each issue a 7-year bond in either the US$ or SFr market.Firm A enjoys an absolute advantage in both credit markets.11.5%10%5%6%Firm AFirm BUS$financeSFr
16 The basic cash flows of a currency swap Firm A has a comparative advantage in borrowing US$, whilefirm B has a comparative advantage in borrowing SFr.Difference(A-B)-1.5%-1.0%- 0.5%11.5%10%5%6%Firm AFirm BUS$financeSFrBy borrowing in their comparative advantage currencies and then swapping, lower cost financing is possible.
17 The basic cash flows of a currency swap $ at t 0SFr at t 010.75% (US$) [t 1 - t 7]5.5% (SFr) [t 1 - t 7]ABorrows $at 10%for 7 yearsBBorrows SFrat 6%$ at t 7SFr at t 7Together, A and B save 0.5%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.
18 Other types of swaps“Plain Vanilla” Interest (Fixed-for-Floating) Rate SwapsOne counterparty exchanges the interest payments of a floating-rate debt obligations for the fixed-rate interest payments of the other counterparty.Currency-Interest Rate Swaps:One counterparty exchanges the floating-rate debt service obligations of a bond denominated in one currency for the fixed-rate debt service obligations denominated in the other currency.
19 Currency swapsWhat risks exist in entering into a swap and maintaining it?interest rate riskexchange rate riskcredit risk
20 ExampleIn 1998 several Korean banks refused to pay the American banks hundreds of millions of dollars owed under deals involving currency swapsSwap contracts were signed on the assumption that the underlying currency would remain stable.SK Securities sued J.P. MorganJ.P. Morgan sued SK SecuritiesSK Securities claimed J.P. Morgan missinformed its customersWhen the baht started to fall, J.P. Morgan told its customers that the currency would soon stabilize and insisted his client has ample evidence to back its claims
21 The basic cash flows of a IR swap Firms A and B can each issue a 7-year US$ denominated bond in either fixed-rate or floating-rate terms.Firm A enjoys an absolute advantage in both credit markets?10.5%9%LIBOR+0.0%+0.5%Firm AFirm BFixed-ratefinanceFloating-
22 The basic cash flows of a IR swap Firm A has a comparative advantage in the fixed-rate bond market, while firm B has a comparative advantage in the floating-rate bond market.Difference(A-B)-1.5%- 0.5%- 1.0%10.5%9%LIBOR+0.0%+0.5%Firm AFirm BFixed-ratefinanceFloating-By borrowing in their comparative advantage markets and then swapping, lower cost financing is possible.
23 The basic cash flows of a IR swap 9.75%LIBOR + .25Interest payments to each other in years t 1 to t 7.ABBorrows at9.0%fixedfor 7 yearsLIBOR %floatingTogether, A and B save 1%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.
24 The pricing of swapsThe swap price should be based on the net present value of the expected future cash flowsIn addition, numerous parity or arbitrage linkages among swap contracts aid in the determination of swap prices
25 The pricing of swapsCurrency XCurrency YFixed RateAsset or LiabilityFloating RateInterest Rate BaseCurrency of DenominationTwo currencies, X and Y, have both fixed-rate and floating-rate segments.Fixed-Fixed Currency SwapAInterest Rate SwapBCCrossCurrencyInterest RateSwapInterest Rate SwapFloating-Floating Currency SwapDFor example, with an interest rate swap in currency X (AB) and a fixed-fixed currency swap (AC), we can construct a cross currency interest rate swap (BC).