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INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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Chapter Objective: This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk. 14 Chapter Fourteen Interest Rate and Currency Swaps 14-1

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Chapter Outline Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? Types of Swaps Size of the Swap Market The Swap Bank Swap Market Quotations Interest Rate Swaps Currency Swaps Variations of Basic Interest Rate and Currency Swaps Risks of Interest Rate and Currency Swaps Is the Swap Market Efficient? 14-2

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Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. 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. 14-3

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Size of the Swap Market In 2007 the notational principal of: Interest rate swaps was $271.9 trillion USD. Currency swaps was $12 trillion USD The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling 14-4

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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. 14-5

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Swap Market Quotations Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs They also 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. 14-6

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Interest Rate Swap Quotations Euro-€£ SterlingSwiss francU.S. $ BidAskBidAskBidAskBidAsk 1 year2.342.375.215.220.920.983.543.57 2 year2.622.655.145.181.231.313.903.94 3 year2.862.895.135.171.501.584.114.13 4 year3.063.095.125.171.731.814.254.28 5 year3.233.265.115.161.932.014.374.39 6 year3.383.415.115.162.102.184.464.50 7 year3.523.555.105.152.252.334.554.58 8 year3.633.665.105.152.372.454.624.66 9 year3.743.775.095.144.482.564.704.72 10 year3.823.855.085.132.562.644.754.79 3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR The convention is to quote against U.S. dollar LIBOR. 14-7

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Swap Quotations 3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR Swap Bank Firm A Firm B €3.82%€3.85%$LIBOR While most swaps are quoted against “flat” dollar LIBOR, “off-market” swaps are available where one party pays LIBOR plus or minus some number. 14-8

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Example of an Interest Rate Swap Consider firms A and B; each firm wants to borrow $40 million for 3 years. FixedFloating A5%LIBOR B5.50%LIBOR +.20% Firm A wants finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate. A has good credit and can borrow at LIBOR Firm B wants finance an interest-rate-insensitive asset and therefore wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow at 5.5% The swap bank quotes 5.1—5.2 against dollar LIBOR for a 3-year swap. 14-9

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Example of an Interest Rate Swap Firm A 5.10%LIBOR Bank X Swap Bank 5.0% If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.1—5.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR – 0.10% A’s all-in-cost: = 5.0% + LIBOR – 5.10% = LIBOR – 0.10% 14-10

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Example of an Interest Rate Swap Firm B 5.20% Bank Y Swap Bank LIBOR LIBOR +.2% If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.1—5.2 they can convert their floating rate debt into a fixed rate debt at 5.40% B’s all-in-cost: = –LIBOR + LIBOR + 0.20% + 5.20% = 5.40% 14-11

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Example of an Interest Rate Swap Firm B Firm A 5.20%5.10% LIBOR Swap Bank LIBOR The Swap Bank makes 10 basis points on the deal: The Swap Bank’s all-in-cost: = –LIBOR + LIBOR – 5.20% + 5.10% = –0.10% 14-12

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Example of an Interest Rate Swap Firm B Firm A 5.20%5.10% Bank X Bank Y Swap Bank LIBOR 5.0% LIBOR +.2% The notional size is $40 million. The tenor is for 3 years. A earns $40,000 per year on the swap. B earns $40,000 per year on the swap. Swap Bank earns $40,000 per year. 14-13

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Using a Swap to Transform a Liability Firm A has transformed a fixed rate liability into a floater. A is borrowing at LIBOR –.10% A savings of 10 bp Firm B has transformed a floating rate liability into a fixed rate liability. B is borrowing at 5.40% A savings of 10 bp 14-14

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What about the Principal? In our “plain vanilla” interest-only interest rate swap just given, we did not mention swapping the Notational Principal. It could be the case that firm A exchanged principal with their lender (Bank X) and firm B exchanged principal with their outside lender, Bank Y. 14-15

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Cash Flows of an Interest-Only Swap: T = 0 Firm B Firm A Bank X Bank Y Swap Bank $40,000,000 14-16

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Cash Flows of an Interest-Only Swap: T = 1 Firm B Firm A Bank X Bank Y Swap Bank $2,000,000 $1,280,000 Assume LIBOR = 3% $1,200,000 $2,040,000 $2,080,000 A saves $40,000 per year relative to borrowing at LIBOR = 3%. B saves $40,000 per year relative to borrowing at 5.5%. Swap Bank earns $40,000 per year. 14-17

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Cash Flows of an Interest-Only Swap: T = 2 $1,600,000 Firm B Firm A $2,040,000 Bank X Bank Y Swap Bank $2,000,000 $1,680,000 Assume LIBOR = 4% $1,600,000 $2,080,000 A saves $40,000 per year relative to borrowing at LIBOR = 4%. B saves $40,000 per year relative to borrowing at 5.5%. Swap Bank earns $40,000 per year. 14-18

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Cash Flows of an Interest-Only Swap: T = 3 $2,000,000 Firm B Firm A $2,040,000 Bank X Bank Y Swap Bank $42,000,000 $42,080,000 Assume LIBOR = 5% $2,000,000 $2,080,000 A saves $40,000 per year relative to borrowing at LIBOR = 4%. B saves $40,000 per year relative to borrowing at 5.5%. Swap Bank earns $40,000 per year. 14-19

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Example of an Currency Swap Firm A is a U.S. MNC and wants to borrow €40 million for 3 years. Firm B is a French MNC and wants to borrow $60 million for 3 years $€ A$7%€6% B$8%€5% Firm A wants finance euro denominated asset in Italy and therefore wants to borrow euro. A can borrow euro at 6% Firm B wants finance a dollar denominated asset and therefore wants to borrow dollars. B can borrow dollars at 8% The current exchange rate is $1.50 = €1.00 14-20

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Example of a Currency Swap Euro-€U.S. $ BidAskBidAsk 3 year5.005.207.007.20 Suppose that the Swap Bank publishes these quotes. The convention is to quote against U.S. dollar LIBOR. $€ A$7%€6% B$8%€5% Firm A wants finance euro-denominated asset in Italy and wants to borrow euro. A can borrow euro at 6% or they can borrow euro at 5.2% by using a currency swap. 14-21

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$7.0% Example of a Currency Swap Euro-€U.S. $ BidAskBidAsk 5.005.207.007.20 $€ A$7%€6% B$8%€5% Suppose that Firm A borrows $60m at $7%; trades for € at spot. Firm A €5.2% Swap Bank Bank X FOREX Market LIBOR $7.0% (The convention is to quote against U.S. dollar LIBOR.) $60m €40m Firm A then enters in to 2 fixed for floating swaps. 14-22

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$7.2% Example of a Currency Swap Euro-€U.S. $ BidAskBidAsk 5.005.207.007.20 $€ A$7%€6% B$8%€5% Suppose that Firm B borrows €40m at €5%, trades for $. Firm B €5.0% Bank Y Swap Bank FOREX Market LIBOR €40m (The convention is to quote against U.S. dollar LIBOR.) €5% €40m$60m Firm B then enters in to 2 fixed for floating swaps. 14-23

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Example of a Currency Swap Firm B Firm A $7.0%$7.2%€5.2% Bank X Bank Y Swap Bank €5.0% $7.0% €5.0% The notional size is $60m. The tenor is for 3 years. Firm A earns 80 bp per year on the swap and hedges exchange rate risk. Firm B earns 80 bp per year on the swap and hedges exchange rate risk. Swap Bank earns 40 bp per year (20bp in $ and 20bp in €). 14-24

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Cash Flows of the Swaps: T = 0 Firm B Firm A Bank X Bank Y Swap Bank $60,000,000 €40,000,000 Foreign Exchange Spot Market €40,000,000 $60,000,000 €40,000,000 $60,000,000 14-25

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Cash Flows of the Swaps: T = 1 Firm B Firm A Swap Bank $4.32m€2m$1.8m $4.2m€2.08m$1.8m Bank X Bank Y Assume LIBOR = 3% $4.2m €2m Firm A’s all-in-cost €2.08m or 5.2% of €40m Firm B’s all-in-cost $4.32 or 7.2% of $60m Swap bank earns €80,000 + $120,000 or.002×€40m +.002×$60m per year. 14-26

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Cash Flows of the Swaps: T = 2 Firm B Firm A Swap Bank $4.32m€2m$2.4m $4.2m€2.08m$2.4m Bank X Bank Y Assume LIBOR = 4% $4.2m €2m 14-27

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Cash Flows of the Swaps: T = 3 Firm B Firm A Swap Bank $4.32m€2m$3m $4.2m€2.08m$3m Bank X Bank Y Assume LIBOR = 5% $64.2m €42m Foreign Exchange Forward Market $60m €40m $60m €40m 14-28

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Example of a Direct Currency Swap Firm B Firm A $7.0% Bank X Bank Y €5.0% $7.0% €5.0% The problem is of course that the swap bank is acting as a broker (or even a dealer) and providing a service—that’s why they get paid. Signing 1 contract is less work than 4. $€ A$7%€6% B$8%€5% If firms A and B knew and trusted each other, they could theoretically cut out the swap bank: 14-29

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Equivalency of Currency Swap Debt Service Obligations We can assume that IRP holds between the €5% euro rate and the $7% dollar rate. This is reasonable since these rates are, respectively, the best rates available for each counterparty who is well known in its national market. According to IRP: $€ A$7%€6% B$8%€5% S t ($/€) = S 0 ($/€) × (1 + i $ ) t (1 + i € ) t S 1 ($/€) = $1.50×(1.07) 1 €1.00×(1.05) 1 $1.5286 €1.00 = 14-30

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IRR0123 7.00%–$60.00$4.20 $64.20 5.00%–€40.00€2.75€2.70€40.44 The swap bank could borrow $60m at 7% and use a set of 3 forward contracts to redenominate their bond as a 5% euro bond. –€40m = –$60m× €1.00 $1.50 €2.7477m = $4.20m× $1.50×(1.07) €1.00×(1.05) €2.6963m = $4.20m× $1.50×(1.07) 2 €1.00×(1.05) 2 €40.4446m = $64.20m× $1.50×(1.07) 3 €1.00×(1.05) 3 14-31

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IRR0123 5.00%–€40.00€2.00 €42.00 7.00%–$60.00$3.06$3.12$66.67 The swap bank could borrow €40m at 5% and use a set of 3 forward contracts to redenominate their bond as a 7% dollar bond. –$60m = –€40m× $1.50 €1.00 $3.06m = €2m × × €1.00×(1.05) $1.50×(1.07) $3.12m = €2m ×× €1.00×(1.05) 2 $1.50×(1.07) 2 $66.67m = €42m× €1.00×(1.05) 3 $1.50×(1.07) 3 14-32

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Equivalency of Currency Swap Debt Service Obligations The ability to hedge with covered interest arbitrage is where the swap bank found the €5% and $7% rates Euro-€U.S. $ BidAskBidAsk 5.005.207.007.20 Competition from other swap banks will keep their spreads from getting too wide—the theoretical limit is 200 basis points total. (See QSD on next slide.) 14-33

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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. $€ A$7%€6% B$8%€5% QSD1%––1%= 2% The QSD is calculated as the difference between the differences. 14-34

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Comparative Advantage as the Basis for Swaps $€ A$7%€6% B$8%€5% A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in euro. 14-35

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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. 14-36

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Risks of Interest Rate and Currency Swaps Interest Rate Risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged 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. 14-37

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Risks of Interest Rate and Currency Swaps (continued) Credit Risk This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap. Mismatch Risk It’s 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. 14-38

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Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: Any swap’s value is the difference in the present values of the payment streams that are incoming and outgoing. Plain vanilla fixed for floating swaps get valued just like a pair of bonds. Currency swap gets valued just like two nests of currency forward contracts. 14-39

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Swap Pricing Example A currency swap has a remaining life of 18 months. It involves exchanging interest at 14% on £20 million for interest at 10% on $30 million once a year. The term structure of interest rates is currently flat in both the US. And the U.K. and if the swap were negotiated today the interest rates exchanged would be $8% and £11%. All rates were quoted with annual compounding. The current exchange rate is $1.65 = £1. What is the value of the swap to the party paying dollars? 14-40

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Answer 06 18 £2.8m –$3m Value of the swap to the party paying dollars: –$5,559,669 = $8,335,659 = £2.8m (1.11) ½ £2.8m (1.11) 3 /2 + $1.65 £1 × –$3m (1.08) ½ –$3m + (1.08) 3/2 $2,775,990 14-41

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Swap Market Efficiency Swaps offer market completeness and that has accounted for their existence and growth. Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures. 14-42

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Concluding Remarks The growth of the swap market has been astounding. Swaps are off-the-books transactions. Swaps have become an important source of revenue and risk for banks 14-43

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End Chapter Fourteen But here’s a couple of sample problems… 14-44

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Sample Interest Rate Swap Problem A is a credit-worthy firm A can borrow at 8% fixed A can borrow at flat LIBOR A prefers to borrow floating B is a less-credit-worthy firm B can borrow at 9% fixed B can borrow at LIBOR + ½% B prefers to borrow fixed Both firms want a 10-year maturity Devise a swap that is mutually beneficial for A and B. Follow the convention of pricing against “flat” LIBOR. FixedFloating A8%LIBOR B9%LIBOR + ½ 14-45

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AB Swap Bank Outside Lender X Outside Lender Y FixedFloating A8%LIBOR B9%LIBOR + ½ QSD = 1% – ½% = ½% Step 1: A is better at borrowing fixed; B is better at borrowing floating so have them borrow externally according to their comparative advantage Step 2: We are to quote the swap against flat LIBOR 8% (Step 1) LIBOR + ½ (Step 1) LIBOR (Step 2) LIBOR (Step 2) Step 3: The QSD = ½ so we have 50 bp to distribute among 3 players. Let’s try 20 for A and B, (this leaves 10 bp for the swap bank) 8.2% (Step 3) 8.3% Step 4: check our work A’s all-in-cost: LIBOR – 0.2 B’s all-in-cost: 8.8% Swap Bank Profit: 10 basis points 14-46

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Sample Currency Swap Problem A is an Italian firm A can borrow in euro at €5% fixed A prefers to borrow in dollars but faces $8% cost B is an American firm B has already borrowed in dollars at $8½% 5 years ago they issued a 15-year bond B now prefers to borrow in euro but faces €6% cost Both firms want a 10-year maturity Devise a feasible swap that eliminates exchange rate risk for A and B

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Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. AB Swap Bank Outside Lender X Outside Lender Y Step 1: A is better at borrowing €; B is better at borrowing $ so have them borrow externally according to their comparative advantage Step 2: We are to eliminate exchange rate risk for A and B €5% (Step 1) $8½% (Step 1) $8½% (Step 2) Step 3: The QSD = ½ so we have 50 bp to distribute among 3 players. Let’s try 20 for A and B, (this leaves 10 bp for the swap bank) $7.8% (Step 3) €5.8% Step 4: check our work A’s all-in-cost: $7.8% B’s all-in-cost: €5.8% Swap Bank Profit: 10 basis points at current exchange rate €5%

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Chapter 13 Pricing and Valuing Swaps

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