Slides prepared by Kaye Watson Chapter 20 Interest Rate Swaps and Currency swaps Websites: http://www.bis.org http://www.afma.com.au Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson Learning Objectives Understand how interest rate and currency swaps operate Outline the various risks associated with swaps Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.1 Introduction Turnover in the Australian swap market in 2000/01 was AUD1.47 trillion Swaps may be used to hedge interest risk and exchange rate risk Swaps also enable investors and borrowers to obtain a lower cost of funds or a higher yield Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.2 Interest Rate Swaps Organised between borrowing parties The two parties swap their interest payment obligations No transfer of the principal amount Both parties benefit from the swap Example: Table 20.1 outlines the current cost of funds for two borrowers Firm A has a credit advantage in both markets Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Strategy Firm A borrows in fixed market, where it has comparative advantage (i.e. 12%) Firm B borrows in other market (i.e. floating) at BBSW + 1.70%. One possible swap arrangement B pays A a fixed rate of 13.60% A pays B a floating rate of BBSW + 1.70% Figure 20.1 illustrates the flow of funds and benefits of this interest rate swap Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) The majority of swaps require the involvement of an intermediary e.g. merchant bank, that often seeks an offsetting ‘matched swap’ i.e. It enters into opposite swap transactions to offset its net swap exposure, making a profit through a spread between the rates Figures 20.2 and 20.3 in the textbook illustrate an intermediated interest rate swap Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Rationale for the existence of interest rate swaps Comparative advantage For a comparative advantage to exist, the advantage in the fixed market must be different from that in the floating market (i.e. different risk premium) Why does this occur? Segmentation between floating and fixed debt markets (i.e. some types of institutions lend more heavily in floating markets while others lend more heavily in fixed markets) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Rationale for the existence of interest rate swaps (cont.) Comparative advantage and efficient markets Despite exploitation of arbitrage opportunities that have reduced the possibility of profitable swap arbitrage arrangements, the interest rate swap market continues to grow for other reasons Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Other explanations for the growth of the swap market Participants developed and used existing products that previously were not the subject of swaps e.g. zero coupon bond swaps, dual-currency and multi-currency bond swaps Change in reasons for the use of swaps Managing or hedging existing interest rate and exchange rate exposures Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Hedging existing interest rate exposures Example: a firm has an existing floating-rate loan and is concerned floating rates will rise Strategy: a firm is able to synthesise (create) a fixed cost loan by Paying a fixed rate to the swap counterparty Receiving a floating payment from counterparty Effect: if floating rate rises, firm’s payments to floating rate lenders increases, but are matched by increase in receipts from swap counterparty, and payment to counterparty remains fixed Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Hedging existing interest rate exposures (cont.) Example: a firm has an existing fixed-rate liability and is concerned floating rates will fall Strategy: a firm is able to synthesise (create) a floating-rate cost of funds by Paying a floating rate to the swap counterparty Receiving a fixed rate payment from counterparty Effect: fixed rate payment received from counterparty is used to pay fixed-rate lenders, leaving the firm to make only a net floating-rate payment Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Hedging existing interest rate exposures (cont.) Example: a firm is locked into a fixed-rate debt (15%) above current interest rates charged on fixed-rate funds (13%) Strategy: a firm refinances at current lower fixed costs (see Figure 20.5) Pays floating-rate payments at BBSW (assume 12%) Receives fixed rate payments at 13% Effect: cost savings, if any, equivalent to gap between lower BBSW and higher fixed swap at 13% Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.2 Interest Rate Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps Two parties exchange debt denominated in different currencies Interest payments are exchanged Principals exchanged at beginning of agreement and then re-exchanged at conclusion of agreement Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Example Table 20.3 indicates there is a cost-of-funds benefit from the swap agreement of 0.25% p.a. Assuming X prefers USD and Y prefers AUD Strategy X borrows AUD20 million and transmits it to Y Y borrows USD15.2 million and transmit it to X Exchange rate is AUD/USD0.7600 X and Y agree on the interest payment swap rates Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Example (cont.) X and Y interest payment swap rates X pays 11.75% in USD to Y Y pays 9.875% in AUD to X Both secure a cost of funds at 0.125% lower than if they had borrowed their preferred currency in their own right Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Example (cont.) X and Y re-exchange funds at maturity of swap X transmits USD15.2 million to Y Y transmits AUD20 million to X At original exchange rate of AUD/USD0.7600 Effect While FX risk is eliminated, both X and Y will need to purchase the relevant interest and principal amounts at the current exchange rate when due Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Rationale for the existence of currency swaps Obtaining lower cost of funds Borrowers may obtain better terms by borrowing in different markets including those denominated in foreign currencies; thus, creating the need for currency swaps Hedging FX risk Two companies can follow their comparative advantage in the debt markets and enter a currency swap Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.3 Currency Swaps (cont.) Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.4 Credit and Settlements Risks Associated with Swaps Credit risk Most swaps are through an intermediary Intermediary is at risk if one of the two counter-parties defaults Intermediary is exposed to interest rate risk (i.e. uncertainty associated with fixed and floating markets) Exposure of intermediary limited to the difference between what a firm would have paid to, and received from, the intermediary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

20.4 Credit and Settlements Risks Associated with Swaps (cont.) Settlement risk The risk that due to timing differences, one party to a transaction will not settle while the other party does settle Significant time zone differentials can create this timing difference Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson Chapter Organisation 20.1 Introduction 20.2 Interest Rate Swaps 20.3 Currency Swaps 20.4 Credit and Settlements Risks Associated with Swaps 20.5 Summary Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson

Slides prepared by Kaye Watson 20.5 Summary Swaps facilitate the exchange of specified cash flows Interest rate swaps are used to Reduce the cost of borrowing Manage existing interest rate exposures Currency swaps are used when an interest rate swap involves borrowing in different currencies Allow management of interest rate and FX risk exposure Currency swaps differ from interest rate swaps in that the principal amounts raised by the two borrowers are are swapped at the commencement and re-exchanged at the end of the agreement Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson