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1 HEDGING CURRENCY RISKS: SWAPS. 2 Currency and interest rate swaps A swap agreement between two parties commits each counterparty to exchange an amount.

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Presentation on theme: "1 HEDGING CURRENCY RISKS: SWAPS. 2 Currency and interest rate swaps A swap agreement between two parties commits each counterparty to exchange an amount."— Presentation transcript:

1 1 HEDGING CURRENCY RISKS: SWAPS

2 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 expires In the case of a currency swap, there is an initial exchange of currency and a reverse exchange at maturity

3 3 Foreign currency swap A 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 4 Dell SFr Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country… “Plain-Vanilla” foreign currency swap

5 5 Nestle SFr$ Nestle would like to borrow in Dollars to hedge its sales to the U.S... SFr Dell “Plain-Vanilla” foreign currency swap

6 6 But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms. Nestle SFr$ Dell “Plain-Vanilla” foreign currency swap

7 7 Nestle I-Bank SFr$ But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them... Nestle SFr$ Dell “Plain-Vanilla” foreign currency swap

8 8 DellNestle SFr$ …and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans... $ Sfr I-Bank DellNestle I-Bank SFr$ Nestle SFr$ Dell “Plain-Vanilla” foreign currency swap

9 9 DellNestle SFr$ …in return for making the payments in the foreign currency that exactly match the other firm’s obligations. $ Sfr $ I-Bank DellNestle I-Bank SFr$ Nestle SFr $ Dell “Plain-Vanilla” foreign currency swap

10 10 I-Bank DellNestle SFr$ In other words, the swap effectively ‘completes the market’. Giving each firm access to the foreign debt market at reasonable terms. $ Sfr $ DellNestle SFr $ Nestle $ Dell “Plain-Vanilla” foreign currency swap

11 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 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 13 Accidents in risk management Corporate Sector Organization Year Losses Contracts Procter & Gamble 1994 $102 million Interest rate swap (U.S.) Gibson Greetings 1994 $20 million Interest rate swap (U.S.) Showa Shell 1993 $1.54 billion Foreign exchange (Japan) Metallgesellschaft 1993 $1.3 billion Oil futures (Germany) Allied Lyons 1991 $265 million Foreign exchange (U.K.) options

14 14 Public Agencies Organization Year Losses Contracts State of Wisconsin 1995 $95 million Interest rate swaps Investment Board (U.S.) Orange County 1994 $1.7 billion U.S. government (U.S.) securities and interest rate derivatives British Councils 1986 $900 million Interest rate swaps (U.K.)-1988 Accidents in risk management

15 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 B US$ finance SFr finance

16 16 Firm A has a comparative advantage in borrowing US$, while firm B has a comparative advantage in borrowing SFr. Difference (A-B) -1.5% -1.0% - 0.5% By borrowing in their comparative advantage currencies and then swapping, lower cost financing is possible. 11.5%10% 5%6% Firm AFirm B US$ finance SFr finance The basic cash flows of a currency swap

17 17 Together, 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 % (US$) [t 1 - t 7 ] 5.5% (SFr) [t 1 - t 7 ] $ at t 7 SFr at t 7 $ at t 0 SFr at t 0 A Borrows $ at 10% for 7 years B Borrows SFr at 6% for 7 years The basic cash flows of a currency swap

18 18 Other types of swaps “Plain Vanilla” Interest (Fixed-for-Floating) Rate Swaps  One 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 19 Currency swaps What risks exist in entering into a swap and maintaining it? interest rate risk exchange rate risk credit risk

20 20 Example In 1998 several Korean banks refused to pay the American banks hundreds of millions of dollars owed under deals involving currency swaps Swap contracts were signed on the assumption that the underlying currency would remain stable. SK Securities sued J.P. Morgan J.P. Morgan sued SK Securities SK Securities claimed J.P. Morgan missinformed its customers When 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 21 The basic cash flows of a IR swap 10.5%9% LIBOR +0.0% LIBOR +0.5% Firm AFirm B Fixed- rate finance Floating- rate finance 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?

22 %9% LIBOR +0.0% LIBOR +0.5% Firm AFirm B Fixed- rate finance Floating- rate finance Difference (A-B) -1.5% - 0.5% - 1.0% 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. By borrowing in their comparative advantage markets and then swapping, lower cost financing is possible. The basic cash flows of a IR swap

23 23 Together, 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. AB Borrows at 9.0% fixed for 7 years Borrows at LIBOR % floating for 7 years 9.75% LIBOR +.25 Interest payments to each other in years t 1 to t 7. The basic cash flows of a IR swap

24 24 The pricing of swaps The swap price should be based on the net present value of the expected future cash flows In addition, numerous parity or arbitrage linkages among swap contracts aid in the determination of swap prices

25 25 Currency X Currency Y Fixed Rate Asset or Liability Floating Rate Asset or Liability Interest Rate Base Currency of Denomination Interest Rate Swap Floating-Floating Currency SwapD Fixed-Fixed Currency Swap A Interest Rate Swap B C Cross Currency Interest Rate Swap Two currencies, X and Y, have both fixed-rate and floating-rate segments. For 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). The pricing of swaps


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