Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 20-1 Chapter 20 Interest Rate Swaps, Currency Swaps and Credit Default Swaps Websites:

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 20-2 Learning Objectives Understand the importance of swap markets Outline the features of an interest rate swap and why they are used to lower the cost of funds and manage risk exposure Examine the structure of a currency swap and show when they may be arranged Structure and calculate an interest rate swap and a currency swap Describe a credit default swap and the parties involved Consider the risks for an intermediary, or a counterparty, to a swap

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 20-3 Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps Notional value of swap market transactions –Australian marketabout AUD3400 billion –International marketsabout USD billion 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps (cont.) 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 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 %. –One possible direct swap arrangement negotiable between firms A and B B pays A a fixed rate of 13.60% A pays B a floating rate of BBSW % Figure 20.1 illustrates the flow of funds and benefits of this interest rate swap

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps (cont.) The majority of swaps require the involvement of an intermediarye.g. merchant bankthat often seeks an offsetting matched swap –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 intermediated interest rate swaps

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Interest Rate Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps Reasons why the use of interest swaps has continued to grow –Lower cost of funds (comparative advantage) –Gain access to otherwise inaccessible debt markets –Hedge interest-rate risk exposures –Lock-in profit margins on economic transactions

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.) Lowering the net cost of funds (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 Some types of institutions lend more heavily in floating markets (commercial banks) while others lend more heavily in fixed markets (life insurance offices, superannuation funds and unit trust funds)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.) Lowering the net cost of funds (comparative advantage) (cont.) –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 –Table 20.2 indicates how interest rates in the two markets might adjust to remove the possibility of a profitable swap based on comparable advantage

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.) Gaining access to otherwise inaccessible debt markets –Banks generally prefer lending at floating rates because it allows then to maximise their spread on loans when interest rates are changing Despite this banks may provide limited funding to a client at fixed rates with the balance lent at floating rates –Corporate borrowers able to issue fixed interest bonds must have a good credit rating Other borrowers obtain floating-rate funds from banks and use a swap to obtain net fixed-rate cost of funds

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.) Hedging existing interest rate exposures –Example: a firm has an existing floating-rate loan and is concerned that 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 the counterparty Effect: if floating rate rises, firms payments to floating rate lenders increases, but are matched by increase in receipts from swap counterparty, and payment to counterparty remains fixed

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of 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 the 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.) Lock-in profit margins on economic transactions –A manufacturer or provider of fixed-price goods or services is exposed to any movements in variable costs (such as floating-rate funds) and has an incentive to enter into swap –Locking in a net fixed-costs fund locks in a fixed-profit margin for the firm

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Interest Rate Swaps (cont.) Swaps in practice –In reality more complex swap arrangements exist than the previous examples –Swaps are likely to be more dynamic Existing swaps will be monitored and actively managed Swaps may be reversed when current interest rates change, or when interest rate expectations alter

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 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, usually at the same exchange rate

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.) Example –Table 20.3 indicates there is a cost-of-funds benefit from the currency swap agreement of 0.50% per annum

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.) Example (cont.) –Assuming X prefers USD and Y prefers AUD, a fixed-to- fixed currency swap strategy could be Commencement of swap: currency swap X borrows AUD20 million and transmits it to Y Y borrows USD15.2 million and transmits it to X Exchange rate is AUD/USD X and Y agree on the interest payment swap rates

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.) Example (cont.) Interest payments X pays 11.50% in USD to Y Y pays 9.75% in AUD to X Both secure a cost of funds at 0.25% lower than if they had borrowed their preferred currency in their own right

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.) Example (cont.) Maturity of swap: currency re-exchange At conclusion of the swap agreement, principal amounts are re-exchanged along with the final interest payments –X transmits USD15.2 million to Y –Y transmits AUD20 million to X –At original exchange rate of AUD/USD –Effect While FX risk is eliminated, both X and Y will need to obtain internally or purchase the relevant interest and principal amounts at the current exchange rate when due A notional FX gain or loss can still be made

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Currency Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Currency Swaps Rationale for the existence of currency swaps is the same as for the popularity of interest rate swaps –Lower the net cost of funds –Gain access to otherwise inaccessible debt markets –Hedge interest rate (FX) risk exposures –Lock in profit margins on economic transactions

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Currency Swaps –Lower the net 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 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Rationale for the Existence of Currency Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit Default Swaps Credit risk –Possibility that an obligor (borrower) will not meet a future financial commitment (interest or principal) to a lender Credit default swap (CDS) –An agreement transferring credit risk from the protection buyer to the protection seller on the payment of a premium Premium paid by the protection buyer is typically a number of basis points relative to the credit protection amount

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit Default Swaps (cont.) Credit default swap (CDS) (cont.) –CDS protection seller Institution that writes a CDS, accepting the credit risk of a reference entity and undertaking to compensate the protection buyer if a specified credit default event occurs Typically insurance companies, banks, investment managers and hedge funds that have identified a capacity to accept higher levels of credit risk exposure in their balance sheets –Reference entity An obligor (borrower) with a debt or loan obligation to the CDS protection buyer, e.g. a corporation or government

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit Default Swaps (cont.) Credit default swap (CDS) (cont.) –CDS protection buyer Lender or investor buying a CDS to transfer risk associated with a reference entity Typically banks, portfolio managers and multinational corporations that have identified a need to manage a credit risk exposure in their balance sheets –The CDS specifies a credit default event e.g. bankruptcy, obligation acceleration, obligation default, cash payment failure, repudiation or moratorium of debt by a nation-state

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit Default Swaps (cont.) Credit default swap (CDS) (cont.) –In the event of credit default by the reference entity the most common forms of settlement are Physical settlement Protection buyer delivers the agreed notional value of the debt of the reference entity to the protection seller and receives payment of that amount by the protection seller Cash settlement Protection seller pays a net cash amount to the protection buyer, usually based on the difference between the face value and the current market value of the underlying reference debt instruments

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit Default Swaps (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit and Settlements Risk Associated with Swaps Credit risk –Most swaps are through an intermediary –Intermediary is at risk if one of the two counterparties 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 –Also occurs with currency swaps where a party defaults on the payment of interest or principal

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Credit and Settlements Risk Associated with Swaps (cont.) Settlements risk –With currency swaps settlements risk occurs if one party settles an obligation within its time zone and the other party later defaults within a different time zone Significant time zone differentials can create this timing difference

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger Chapter Organisation 20.1Interest Rate Swaps 20.2Rationale for the Existence of Interest Rate Swaps 20.3Currency Swaps 20.4Rationale for the Existence of Currency Swaps 20.5Credit Default Swaps 20.6Credit and Settlements Risks Associated with Swaps 20.7Summary

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney Slides prepared by Anthony Stanger 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 the 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 swapped at the commencement and re-exchanged at the end of the agreement