1 Currency and Interest Rate Swaps 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. Chapter Outline: Types of Swaps Size of the Swap Market The Swap Bank Interest Rate Swaps Currency Swaps 10 Chapter Ten

2 Swap Market  In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.  There are two basic types of swaps: Single Currency Interest rate swap “Plain vanilla” fixed-for-floating swaps in one currency. Cross Currency Interest Rate Swap (Currency swap) Fixed for fixed rate debt service in two (or more) currencies.  2006 Notional Principal for: Interest rate swaps: US$ trillion !! Currency swaps: US$ 10.8 trillion  The most popular currencies are: US$, Yen, Euro, SF, BP

3 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.

4 Interest Rate Swap  Used by companies and banks that require either fixed or floating-rate debt.  Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments.  Since principal is in the same currency and the same amount, only interest payments are exchanged (net).

5 Interest Rate Swap  Each party will issue the less advantageous form of debt. Swap Bank Company A prefers floating Company B prefers fixed Pay fixed Pay floating Receive Floating Receive fixed Issue floating Issue fixed

6 An Example of an Interest Rate Swap  Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M to finance floating-rate Eurodollar loans. It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %  Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a five-year economic life. Firm B can issue 5-year fixed-rate Eurodollar bonds at % Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR percent. Firm B would prefer to borrow at a fixed rate because it locks in a financing cost. The borrowing opportunities of the two firms are:

7 The Quality Spread Differential  QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank.  QSD arises because of a difference in default risk premiums for fixed (usually larger) and floating rate (usually smaller) instruments for parties with different credit ratings  There is no reason to presume that the gains will be shared equally, usually the company with the higher credit rating will take more of the QSD.  In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

8 An Example of an Interest Rate Swap The swap bank makes this offer to Bank A: You pay LIBOR per year on $10 million for 5 years and we will pay you 10.50% on $10 million for 5 years Swap Bank LIBOR 10.50% Bank A Issue $10M debt at 10% fixed-rate

9 An Example of an Interest Rate Swap Here’s what’s in it for Bank A: Bank A can borrow externally at 10% fixed and have a net borrowing position of % + 10% + LIBOR = LIBOR – 0.50% which is 0.50 % better than they can borrow floating without a swap. 10% 0.50% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Swap Bank LIBOR 10.50% Bank A

10 An Example of an Interest Rate Swap Company B The swap bank makes this offer to company B: You pay us 10.75% per year on $10 million for 5 years and we will pay you LIBOR per year on $10 million for 5 years. Swap Bank 10.75% LIBOR Issue $10M debt at LIBOR+0.50% floating-rate

11 An Example of an Interest Rate Swap Firm B can borrow externally at LIBOR +.50 % and have a net borrowing position of (LIBOR +.50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating (11.75%). LIBOR +.50% Here’s what’s in it for Firm B: 0.5 % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank Company B 10.75% LIBOR

12 An Example of an Interest Rate Swap The swap bank makes money too..25% of $10 million = $25,000 per year for 5 years. LIBOR+10.75%– LIBOR-10.50%=0.25% Swap Bank Company B 10.75% LIBOR 10.50% Bank A

13 An Example of an Interest Rate Swap Swap Bank Company B 10.75% LIBOR 10.50% Bank A B saves.50% A saves.50% The swap bank makes.25%

14 Example: Interest Rate Swap  Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed)  Company B can borrow at 9.5% fixed or LIBOR +.5% (borrows floating)  Company A prefers floating and Company B prefers fixed  By entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes.5% PayReceiveNet Company ALIBOR8% -(LIBOR+.25) Swap Dealer w/A7.75%LIBOR Company B8.25%LIBOR-8.75% Swap Dealer w/BLIBOR8.5% Swap Dealer NetLIBOR+7.75%LIBOR+8.25%+0.50%

15 Currency Swaps  Most often used when companies make cross- border capital investments or projects. Ex., U.S. parent company wants to finance a project undertaken by its subsidiary in Germany. Project proceeds would be used to pay interest and principal. Options: 1. Borrow US$ and convert to Euro – exposes company to exchange rate risk. 2. Borrow in Germany – rate available may not be as good as that in the U.S. if the subsidiary is relatively unknown. 3. Find a counterparty and set up a currency swap.

16 Currency Swaps  Typically, a company should have a comparative advantage in borrowing locallyissue local Swap Bank Company A Company B Pay foreign pay foreign Receive local Receive local Issue local

17 An Example of a Currency Swap  Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a German plant.  They could borrow dollars in the U.S. where they are well known and exchange for dollars for euros. This will give them exchange rate risk: financing a euro project with dollars.  They could borrow euro in the international bond market, but pay a premium since they are not as well known abroad.  If they can find a German MNC with a mirror-image financing need they may both benefit from a swap.  If the spot exchange rate is S 0 ($/ €) = $1.30/ €, the U.S. firm needs to find a German firm wanting to finance dollar borrowing in the amount of $52,000,000.

18 An Example of a Currency Swap  Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a Germany–based multinational.  Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

19 $8% An Example of a Currency Swap Firm B $8% € 6% Swap Bank Firm A € 6% $8% € 6% Borrow $52M Borrow € 40M Annual Interest $4.16M Annual Interest €2.4 M Annual Interest $4.16M Annual Interest €2.4 M

20 $8% An Example of a Currency Swap Firm B $8% € 6% Swap Bank Firm A € 6% $8% € 6% $52M€ 40M A’s net position is to borrow at € 6% B’s net position is to borrow at $8%

21 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” and currency swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.  Interest Rate Swap Example:  Swap bank terms: USD: 2.50 – 2.65 Means that the bank is willing to pay fixed-rate 2.50% interest against receiving LIBOR OR bank is willing to receive fixed-rate 2.65% against paying LIBOR.  Currency Swap Example:  Swap bank terms: USD 2.50 – 2.65 Euro 3.25 – 3.50 Means that bank is willing to make fixed rate USD payments at 2.5% in return for receiving fixed rate Euro at 3.5% OR the bank is willing to receive fixed-rate USD at 2.65% in return for making fixed-rate Euro payments at 3.25%

22 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  Floating rates of the two counterparties being pegged to two different indices Exchange rate Risk  Exchange rates might move against the swap bank after it has only gotten half of a swap set up. 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.