Presentation on theme: "1 Admin News Final’s date: 60% liked 12/18 (Registrar-set date). => So, final will be 12/18. Some of you had emergency reasons & wound not be able."— Presentation transcript:
1 Admin News Final’s date: 60% liked 12/18 (Registrar-set date). => So, final will be 12/18. Some of you had emergency reasons & wound not be able to make it => expect an from me. Quiz V next Tuesday… If absolutely can’t come, please let me know… Will try to accommodate you. Otherwise, weight goes to final
4 Interest Rate Risk Fact: all firms sensitive to interest rate changes. MNE: differing currencies have differing interest rates => interest rate risk larger! Reference rate rate of interest used in standardized quotation, loan agreement, or financial derivative valuation Most common: LIBOR (London Interbank Offered Rate).
5 Credit and Repricing Risk Credit (roll-over ) Risk: risk of change of borrower creditworthiness when renewing credit. Repricing risk: risk of changes in interest rates charged (earned) when financial contract rate is reset. For Example: three debt strategies #1: Borrow $1 million for 3 fixed rate. #2: Borrow $1 million for 3 floating rate, LIBOR + 2% reset annually. #3: Borrow $1 million for 1 fixed rate, renew credit annually
6 How to hedge floating-rate loans risk? Assume floating-rate loan for US$10 m. Serviced w/ annual payments Bullet principal end third year Loan US$ LIBOR %. LIBOR reset annually. At time 0, up-front fee of 1.50%. Do we know the actually cost?
7 Floating-Rate Loan: Example
8 How to manage a floating rate loan? Alternatives Refinancing –refinance the entire agreement. Forward Rate Agreement (FRA) –lock in future interest rate payment (as w/ forex forward contracts). Interest Rate Futures Interest Rate Swaps –Could swap floating rate note for fixed rate note w/ swap dealer.
9 Forward Rate Agreement (FRA) Interbank-traded contract to buy or sell interest rate payments on notional principal. E.g.: If you wish to lock in first payment, buy a FRA which locks total interest 6.5% –If LIBOR above 5% => receive cash payment from FRA seller reducing LIBOR payment to 5% –If LIBOR below 5% => pay FRA seller cash amount increasing LIBOR payment to 5% –So you locking in payment of 5%+1.5%!
10 Interest Rate Futures Very often used (unlike forex futures) high liquidity of interest rate futures markets standardized interest rate exposures firms Exchange-traded Chicago Mercantile Exchange (CME). Chicago Board of Trade (CBOT). London Intl Financial Futures & Options Exchange (LIFFE). Yield calculated from settlement price ExposureActionInterest Rate Outcome Paying interest Short future Rates up Rates down P futures down (short: profit) P futures up (short: loss) Earning interest Long future Rates up Rates down P futures down (long: loss) P futures up (long: profit)
12 Interest Rate & Currency Swaps Contractual agreements to exchange (swap) series of cash flows. Commits each counterparty to exchange amount of regular intervals, until expiration. Interest rate swap: agreement to swap fixed interest payment for floating rate payment. Currency swap: agreement to swap currencies of debt service => initial currency exchange & maturity. Swap may combine elements of both interest rate and currency swap. Swap itself not source of capital!
13 Interest Rate Swaps Strategies Swap = collection of forward contracts for exchange of maturities. reduces transaction costs. legal structure of swap transaction reduce counterparty risk. Interest rate swap cash flows: interest rates applied to a notional principal, but no principal is swapped! PositionExpectationStrategy Fixed-Rate DebtRates up Rates down Stay put Pay floating/Receive Fixed Floating-Rate DebtRates up Rates down Pay fixed/Receive floating Stay put
14 Example: swapping to fixed rates Expect rates will rise over life of loan. => interest rate swap pay fixed/receive floating would be best. Bank quotes you 5.75% against LIBOR The swap does not replace the original loan, must still make payments at original rates! Swap only supplements the loan payments!
15 Interest Rate Swap
16 Currency Swap So far, raised $10m in floating rate financing & swap into fixed rate payments. But, may prefer to make debt-service payments in SF. => would enter into a 3-year pay Swiss francs & receive US$ swap Both interest rates fixed. Will pay 2.01% (ask rate) fixed SF interest & receive 5.56% (bid rate) fixed US$. Spot rate on date of agreement establishes notional principal is in target currency Notional amount of SF 15,000,000. Commit to payments SF 301,500 (2.01% SF15,000,000) The notional amounts part of swap agreement!
17 Currency Swap Source: Financial Times (as quoted by MSE)
18 Swapping US$ to Swiss Francs
19 Unwinding Swaps Can unwind a swap if viewpoints changes… Assume 3-year contract w/ Swiss buyer terminates in one year How to unwind it? Discount remaining cash flows under swap current interest rates. Convert target currency back to home currency
20 Unwinding Swaps Assume two payments left: SF301,500 & SF15,301,500 2-year fixed rate for SF is 2% PV swap commitment PV of remaining cash flows on the $-side of swap is determined using current 2 year fixed dollar rate 5.5% PV net inflows $10,011,078. PV net outflows SF 15,002,912. If current spot SF 1.465/$ net settlement
21 Counterparty Risk Potential exposure any firm bears that second party to financial contract will be unable to fulfill obligations. A firm entering into a swap agreement retains the ultimate responsibility for its debt-service. In event swap counterpart defaults, payments would cease. The real exposure: not total notional principal, but mark-to-market value of differentials!
22 3-way Cross Currency Swap Province of Ontario (Canada) Borrows $390 US Treasury + 48 b.p. Finish Export Credit (Finland) Borrows C$300 Canadian Treasury + 47 b.p. Inter-American Development Bank Borrows C$150 Canadian Treasury + 44 b.p. $260 million C$300 million $130 million C$150 million Sometimes firms enter into loan agreements w/ swap already in mind, creating debt issuance coupled w/ swap from inception…
23 Things to remember… Interest rate risk? Credit & Repricing risks What hedging strategy? Refinancing Forward Rate Agreement Interest Rate Future Interest Rate Swap Currency Swap (& how to undo them) Counterparty Risk. Cross Currency Swaps.