1. Interest rate swaps, currency swaps and credit default swaps
Chapter 21
Interest rate swaps, currency swaps and credit default swaps
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2. Learning objectives
Describe the nature of a swap and explain the structure and operation of vanilla and basis interest rate swaps
Understand the importance of the interest rate swap market
Examine the structure of a cross-currency swap and how they can be arranged
Explain the rationale for the cross-currency swap markets
Introduce the concepts and parties to credit default swaps
Consider the risks for an intermediary, or a counterparty, to a swap

3. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

4. 21.1 Interest rate swaps (cont.)
Notional value of swap market transactions in 2010
Australian market
Interest rate swaps AUD billion
Currency swaps AUD billion
Credit derivatives AUD 247 billion
International markets
Interest rate swaps USD billion
Currency swaps USD billion
Credit default swaps USD billion
Note: the figures are not comparable. The Australian market figures are annual turnover while the international figures are notional value at a point in time.
(cont.)

5. 21.1 Interest rate swaps (cont.)
Swaps may be used to hedge interest risk and exchange rate risk, and also enable investors and borrowers to obtain a lower cost of funds or a higher yield
Organised between borrowing parties
The two parties swap their interest payment obligations
No transfer of the principal amount
Both parties benefit from the swap
(cont.)

6. 21.1 Interest rate swaps (cont.)
Example: Table 21.1 outlines the current cost of funds for two borrowers
Firm A has a credit advantage in both markets
(cont.)

7. 21.1 Interest rate swaps (cont.)
Strategy
Firm A borrows in a fixed market, where it has comparative advantage (i.e. 12%)
Firm B borrows in another 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 21.1 illustrates the flow of funds and benefits of this interest rate swap
(cont.)

8. 21.1 Interest rate swaps (cont.)

9. 21.1 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’
It enters into opposite swap transactions to offset its net swap exposure, making a profit through a spread between the rates
Figures 21.3 and 21.4 in the textbook illustrate intermediated interest rate swaps
(cont.)

10. 21.1 Interest rate swaps (cont.)

11. 21.1 Interest rate swaps (cont.)

12. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

13. 21.2 Rationale for the existence of interest rate swaps
Reasons why the use of interest swaps has continued to grow
Lowering the cost of funds (comparative advantage)
Access gained to otherwise inaccessible debt markets
Hedge interest rate risk exposures
Profit margins locked in on economic transactions
(cont.)

14. 21.2 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)
(cont.)

15. 21.2 Rationale for the existence of interest rate swaps (cont.)
Lowering the net cost of funds (comparative advantage) (cont.)
Despite exploitation of arbitrage opportunities that has reduced the possibility of profitable swap arbitrage arrangements, the interest rate swap market continues to grow for other reasons
Table 21.2 indicates how interest rates in the two markets might adjust to remove the possibility of a profitable swap based on comparable advantage
(cont.)

16. 21.2 Rationale for the existence of interest rate swaps (cont.)

17. 21.2 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 them 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 a net fixed rate cost of funds
(cont.)

18. 21.2 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: the 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, firm’s payments to floating-rate lenders increases, but are matched by increase in receipts from swap counterparty, and payment to counterparty remains fixed
(cont.)

19. 21.2 Rationale for the existence of interest rate swaps (cont.)

20. 21.2 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: the 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
(cont.)

21. 21.2 Rationale for the existence of interest rate swaps (cont.)
Locking 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 a swap
Locking in a net fixed-costs fund locks in a fixed-profit margin for the firm
(cont.)

22. 21.2 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

23. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

24. 21.3 Currency swaps
Two parties exchange debt denominated in different currencies
Interest payments are exchanged
Principals are exchanged at the beginning of an agreement and then re-exchanged at the conclusion of the agreement, usually at the same exchange rate
(cont.)

25. 21.3 Currency swaps (cont.) (cont.) Example:
Table 21.3 indicates there is a cost-of-funds benefit from the currency swap agreement of 0.50% per annum
(cont.)

26. 21.3 Currency swaps (cont.) (cont.) Example (cont.)
Assuming X prefers USD and Y prefers AUD, a fixed-to-fixed currency swap strategy could be the following:
Commencement of swap: currency swap
X borrows AUD20 million and transmits it to Y
Y borrows USD18.4 million and transmits it to X
Exchange rate is AUD/USD0.9200
X and Y agree on the interest payment swap rates
(cont.)

27. 21.3 Currency swaps (cont.)
(cont.)

28. 21.3 Currency swaps (cont.) (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
(cont.)

29. 21.3 Currency swaps (cont.)
(cont.)

30. 21.3 Currency swaps (cont.) (cont.) Example (cont.) Effect
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 USD18.4 million to Y
Y transmits AUD20 million to X
At original exchange rate of AUD/USD0.9200
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
(cont.)

31. 21.3 Currency swaps (cont.)

32. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

33. 21.4 Rationale for the existence of currency swaps
Currency swaps exist for the same reasons interest rate swaps are popular:
Lowering the net cost of funds
Gaining access to otherwise inaccessible debt markets
Hedging interest rate (FX) risk exposures
Locking in profit margins on economic transactions
(cont.)

34. 21.4 Rationale for the existence of currency swaps
Lowering the net cost of funds
Borrowers may obtain better terms by borrowing in different markets, including those denominated in foreign currencies; thus creating a need for currency swaps
Hedging FX risk
Two companies can follow their comparative advantage in the debt markets and enter a currency swap
(cont.)

35. 21.4 Rationale for the existence of currency swaps (cont.)

36. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

37. 21.5 Credit default swaps (cont.) 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
(cont.)

38. 21.5 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
(cont.)

39. 21.5 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
(cont.)

40. 21.5 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
(cont.)

41. 21.5 Credit default swaps (cont.)

42. 21.5 Credit default swaps (cont.)
CDSs attracted a lot of attention during the GFC
In particular, many of the ‘toxic’ mortgage securities were ‘insured’ by CDSs
As the mortgage bond market and mortgage derivatives markets suffered large losses, the CDSs rose in value
This market movement exposed issuers of CDSs to significant and rapidly growing liabilities
American International Group (AIG) was most dramatically impacted.

43. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

44. 21.6 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
(cont.)

45. 21.6 Credit and settlements risk associated with swaps (cont.)
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

46. Chapter organisation
21.1 Interest rate swaps 21.2 Rationale for the existence of interest rate swaps 21.3 Currency swaps 21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps 21.6 Credit and settlements risks associated with swaps 21.7 Summary

47. 21.7 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 commencement and re-exchanged at the end of the agreement