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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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 %.
One possible swap arrangement
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  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
Slides prepared by Kaye Watson

9. 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

10. 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

11. 20.2 Interest Rate Swaps (cont.)
Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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12. 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

13. 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

14. 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

15. 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

16. 20.2 Interest Rate Swaps (cont.)
Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis
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17. 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

18. 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

19. 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. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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