FIN 645: International Financial Management

FIN 645: International Financial Management
Lecture 5 Currency & Interest Rate Swaps

Lecture Outline Types of Swaps Size of the Swap Market The Swap Bank
Interest Rate Swaps Currency Swaps

Lecture Outline (continued)
Swap Market Quotations Variations of Basic Currency and Interest Rate Swaps Risks of Interest Rate and Currency Swaps Swap Market Efficiency Concluding Points About Swaps

Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps: Single currency interest rate swap “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps. Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies. IRS: Both debt obligations are denominated in the same currency Why IRS? To better match cash inflows and outflows and/or to obtain a cost savings. In currency swap, one counterparty exchanges the debt service obligations of a bond denominated in one currency for debt service obligations of the other counterparty denominated in another currency Why currency swap? To obtain debt financing in the swapped denominations at a cost saving and or to hedge long-term foreign exchange risk

Size of the Swap Market In 2007, the total amount of interest rate swaps outstanding was $ trillion($36,262 billion in 1998) and outstanding Currency swaps$12 trillion($2253 billion in 1998) The most popular currencies are: U.S.$ (34%) ¥ (23%) € (21%) £ (6%) notional principal: a reference amount of principal for determining interest payments Phenomenal growth – Interest rate swap- 650 percent; Currency swap-446 percent

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.

Interest Rate Swap in Project Finance Transactions
Definition of Project Finance Three Approaches to Structured Finance Types of Interest Rate What is Interest Rate Risk? What is Interest Rate Swap? Types of Swaps Advantages of Swap Pricing of an Interest Rate Swap Other Derivatives Used in Project Finance Transactions

Definition of Project Finance “The raising of funds to finance a stand-alone capital intensive project in which the providers of the funds look primarily to the cash flow from the project as the source of (a) repayment of their loans, and (b) return on their equity invested in the project” Three important things in project finance: (i) cash flow, (ii) cash flow, (iii) cash flow

Three Approaches to Structured Finance Similarities Use of a newly created shell company, limited recourse Highly leveraged capital structure Debt amortization is tailored CADS Control of Free Cash Flows (FCF) Differences: Project finance mobilizes debt and passive equity for greenfield facility. During the construction period, interest is rolled up and capitalized. Acquisition finance mobilizes debt and quasi equity to purchase an operating company pursuant to a divestiture or merger. Securitization mobilizes debt and equity from investors for the purchase of receivables such as bills, notes, and loans. Acquisition finance and securitization have no construction period, and hence, no rolling-up of interest!

Types of Interest Rate Fixed rate 10% on a 5-year bond Floating/variable rate LIBOR, certificate of deposit, repo rate, average weighted deposit rate (AWDR) of scheduled banks, call money rate, etc. What is Interest Rate Risk? The uncertainty that over the life of the loan, interest rate may move adversely, thereby, causing a huge interest burden for the project

However, there is exchange of notional principal in case of a CURRENCY SWAP.

Important Concepts Notional principal (the amount used as the basis for computations of net payments to be made by swap counter parties) Tenor and payment dates Fixed leg Variable leg Day counting convention Payment netting Counter party: buyer and seller

Day Counting Conventions Number of days between two payment dates X Annual interest rate Notional principal Number of days in a year 3 types of day counting conventions are: actual/365 actual/360 30/360 Borrowed amount $2 million Fixed rate 10 % five years bullet maturity, explain Payment dates 15 March and 15 September actual/365: I = (184/365) x$2,000,000x10% = $ 100,821.91 actual/360: I = (184/360) x$2,000,000x10% = $ 102,222.22 30/360: I = (180/360) x$2,000,000x10% = $ 100,000.00

Payment Netting It is a market convention that the exchange of interest payments between two parties is executed through payment netting. For example, if A owes B more interest payments than B owes on a payment date, only A will make a payment to B equal to the difference between the two payment amounts

Basic Structure Swap would be based on notional principal of $100 million Bank Fixed Interest Rate Variable Interest Rate $ 150 million loan $ 100 million loan Party “A" Party “B" BA: fixed interest rate AB: variable interest rate

An Example Party A agrees to pay 8.75% on $100 million to Party B. Party B agrees to make floating rate payments to Party A in return. However, the actual payment will vary with LIBOR. Year LIBOR Party B Pays Party A (Floating Rate) Party A Pays Party B (Fixed Rate) 8.5% 1 LIBOR1 = ? LIBOR0 X 1,000,000 =0.085 X 100,000,000 =8,500,000 8,750,000 2 LIBOR2 = ? LIBOR1 X 100,000,000 875,0000 3 LIBOR3 = ? LIBOR2 X 100,000,000 4 LIBOR4 = ? LIBOR3 X 100,000,000 5 N/A LIBOR4 X 100,000,000 Net payment made is $250,000

Types of Swaps Plain vanilla swaps, Amortizing swaps, Accreting swaps, Roller coaster swaps, Basis rate swaps, etc.

Types of Swaps: Plain vanilla swaps Floating and fixed payments are regular, e.g. every six months Term of the swap is a whole number of years, e.g. 1, 2, 3, 10 years One party makes fixed rate payments, the other variable rate payments Notional principal remains constant throughout the life of the swaps The fixed rate remains constant throughout the life of the swaps Suitable for loans with Principal repayment at the end of loan life

Types of Swaps: Accreting swaps Used when notional principal increases over time Typical during the construction period

Types of Swaps: Amortizing swaps Used when a loan has scheduled repayments of principal over its term, rather than a bullet repayment structure Notional principal decreases over time

Types of Swaps: Roller coaster swaps Accommodates the characteristics of both amortizing and accreting swaps Typical for large infrastructure projects

Types of Swaps: Other swaps Seasonal swap: An interest rate swap in which the principal alternates between zero and the notional amount (which can change or stay constant). The principal amount of the swap is designed to hedge the seasonal borrowing needs of a company. Off-market swap: In this type of swap, a premium is built into the swap price to fund the purchase of options or to allow for the restructuring of a hedge portfolio. Off-market swaps are generally used to restructure or cancel old swap/hedge deals: essentially, they simulate a refinancing pack-age

Advantages of Swaps Theory of comparative advantage applies i.e. entity should borrow at a rate (fixed/floating) in which it has a comparative advantage. Suppose X and Y are two companies. X’s borrowing situations (in fixed and floating rate) are as follows: Bank (Floating) Bond (Fixed) LIBOR % UST+0.70% Y’s borrowing situations (in fixed and floating rate) are as follows: LIBOR + 1.5% UST+3.50% X has absolute advantage on both bank (floating) and bond (fixed) loans. However, Y has comparative advantage on bank (floating) loans. Note this, for bank loan credit/quality spread of X vs. Y is 1.15%; while for bond it is 2.8%. Hence, Y should borrow at floating rate (from Bank) while X should at fixed rate (from bond market) and swap among themselves and collectively realize total savings of 1.65% (2.8% minus 1.15%), known as quality spread differential. However, how this 1.65% will be shared depends on relative bargaining power. In the illustration that follows, we see that X keeps 1.45% while Y retains 0.2%. X is a well known multinational company Y is a less well- known company

Advantages of Swaps…cont’d Assuming LIBOR and UST are 6% and 8.5% respectively, Bank (Floating) Bond (Fixed) X % (8.5% + 0.7%) Y 7.5%(6% + 1.5%) Assuming X & Y enter into a swap for a fixed rate of 10.3% (Y pays fixed rate to X in exchange of LIBOR). Position of X, therefore is as follows: Pays fixed rate on bond 9.2% p.a. Receives from Y (10.3%) Pays LIBOR to Y 6.0% Total payments 4.9% p.a. Please note it is less than 1.45% of floating rate of LIBOR+0.35%. Position of Y, therefore is as follows: Pays variable rate on bank loan 7.5% p.a. Receives from X (6.0%) Pays fixed rate to X % Total payments % p.a. Please note it is less than 0.2% of fixed rate of UST+3.5%.

The QSD The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. Less credit-worthy entity will probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

Pricing of Swaps…cont’d. PV PV of of PV PV Float Float - - of of ing ing > g Fixed Fixed 7% 7% 7% 7% 7% 7% 7% 7% Leg = Leg = Leg = Leg = $20 $20 $18 $18 Floating Leg Floating Leg mill mill mill mill Fixed Leg Fixed Leg PV PV PV PV of of of of 9% 9% 9% 9% 9% 9% 9% 9% Float Float - - Fixed Fixed ing ing < g Leg = Leg = Leg = Leg = $22 $22 $20 $20 mill mill Floating Leg Floating Leg mill mill Fixed Leg Fixed Leg Price of the Swap Price of the Swap PV PV PV PV of of of of Float Float - - 8% 8% 8% 8% 8% 8% 8% 8% Fixed Fixed ing ing = = Leg = Leg = Leg = Leg = $20 $20 $20 $20 mill mill Floating Leg Floating Leg mill mill Fixed Leg Fixed Leg

Pricing of Swaps Illustration: A $105 million roller coaster swap Loan amount: $105 million variable-rate loan. Tenor: 5 years. Grace period: 21/2 years. Construction period: 2 years; during when interest on loan is rolled up and capitalized. Loan drawdown: 4 equal semi-annual drawdowns; first one commencing at financial closing; while the rest three while facility is being constructed. Repayment profile: 6 level principal; semi-annual. Repayment starts: First repayment commences on six months after construction completion. Problem: Find an equivalent fixed rate based on the same notional principal with same drawdown profile.

Pricing of Swaps…cont’d. Swap Pricing [Shows Calculations] We can solve the forward rate R(1,2) as follows: [1+R(0,1)] x [1+R(1,2)] = [1+R(0,2)]2 [1+9407%] x [1+R(1,2)] = [ %]2 [1+R(1,2)] = [ %]2 / [ %] [1+R(1,2)] = / R(1,2) = = Therefore annualized six month forward rate is 2 x or % Similarly we can solve the forward rate R(2,3) using the following formula: [1+R(0,1)] x [1+R(1,2) x [1+R(2,3)] = [1+R(0,3)]3 Identifying forward rate is central to swap pricing. A swap is, in fact, a series of forward contracts with its own forward rate and notional principal

Other Derivatives Used in Project Finance Transactions Interest rate cap Interest rate floor Interest rate collar

Interest Rate Cap An interest-rate cap is a derivative that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) exceeds a specified strike rate (the "cap rate"). Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate. Each period, the payment is determined by comparing the current level of the index interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period. If a payment is due on a USD Libor cap, it is calculated as

Class Exercise Payments made under a hypothetical interest rate scenario by a 3-year USD 200MM notional cap linked to 6-month USD Libor with strike rate of 7.5%. Values for the index rate are 6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%.

Interest Rate Cap…an example For example, a 3-year, USD 200MM notional cap with 6-month Libor as its index rate, struck at 7.5%. The exhibit shows what the cap's payments would be under a hypothetical interest rate scenario. 200millionx25% = .50million/2 = .25 million Payments made under a hypothetical interest rate scenario by a 3-year USD 200MM notional cap linked to 6-month USD Libor with strike rate of 7.5%. Values for the index rate are 6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%. These result in payments of USD 0MM, USD .25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM.

Interest Rate Floor Interest rate floors compare to interest rate caps are derivatives that protect the holder from declines in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) falls below a specified strike rate (the "floor rate"). Floors are purchased for a premium and typically have maturities between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate. Each period, the payment is determined by comparing the current level of the index interest rate with the floor rate. If the index rate is below the floor rate, the payment is based upon the difference between the two rates, the length of the period, and the contract's notional amount. Otherwise, no payment is made for that period. In US markets, if a payment is due on a USD Libor floor, it is calculated as

An Example of a Currency Swap
Suppose a U.S. MNC wants to finance expansion of its German Subsidiary, the cost is € 40,000,000 Current exchange rate is $0.90/€1, The MNC could borrow $36,000,000 in the U.S. where they are well known and exchange for dollars for Euro. By issuing 5-year bonds at 8% This will give them exchange rate risk: financing a Euro project with dollars. If the dollar appreciates substantially against the euro over the loan period, it may be difficult for the German subsidiary to earn enough in euros to service the loan

They could borrow € 40,000,000 in the international bond market, but pay a lot since they are not as well known abroad. The US firm could borrow 5-year fixed interest rate of 7 percent; The current normal borrowing rate for a well-known firm of equivalent credit worthiness is 6 percent. A German MNC of equivalent creditworthiness has a US subsidiary in need of $36,000,000 to finance capital expenditure with an economic life of five years.

The German parent could raise € 40,000,000 at a fixed interest rate of 6 percent and convert the fund into US dollars to finance the expenditure. Transaction exposure is created. If Euro appreciates the US subsidiary might have difficulty to meet the debt service. The German parent could also issue Eurodollar bonds (or Yankee bond in the US capital market), say at a fixed rate of 9 percent, as it is not well known. A swap bank could arrange a currency swap, instruct each parent firm to raise funds in its national capital market. Then the principal would be exchanged through the swap bank.

Annually, the German subsidiary would remit to its US parent € 2,400,000 in interest(6 percent of € 40,000,000) to be passed through the swap bank to the German MNC to meet Euro debt Service. The US subsidiary would remit to its German parent $2,880,000 in interest(8 percent of $ 36,000,000) to be passed through the swap bank to the US MNC to meet dollar debt Service. At the debt retirement date, the subsidiaries would remit the principal sums to their respective parents through the swap bank to pay off the bond issues in the national capital markets.

Benefits of a Currency Swap
At inception, the principal sums are exchanged at the current exchange rate of $0.90/ € 1= $36,000,000/ € 40,000,000. Each year prior to debt retirement, the swap agreement calls for counterparties to exchange $2,880,000 of interest on US dollar debt for € 2,400,000 of interest on Euro debt; this is a contractual exchange rate of $0.8333/ € 1. At the maturity date, a final exchange, including the last interest payment and the re-exchange of the principal sum would take place; $38,880,000 for € 42,400,000. The contractual exchange rate at year 5 is thus $0.9170/ € 1. Clearly, the swap locks in foreign exchange rates for each counterparty to meet its debt service obligations over the term of the swap. 36x1.08=38.8 million 40x1.06= 42.4 million

US Dollar Euro Currency Swap
German capital ``US capital market @8% 6% 8% Swap Bank US MNC German MNC = = Eurodollar Eurobond Original Principal Exchange Debt Service Re-exchange of principal Euro-denominated Eurobond market7%

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 If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk Exchange rate might move against the swap bank.

Risks of Interest Rate and Currency Swaps (continued)
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.

Swap Market Efficiency
Swaps offer market completeness and that has accounted for their existence and growth. Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

If they can find a British MNC with a mirror-image financing need they may both benefit from a swap. If the exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–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.

Bank $9.4% $8% £12% £11% Company A Company B $8% £12%

Bank $9.4% $8% £12% £11% $8% Company A Company B £12% A’s net position is to borrow at £11% A saves £.6%

Bank $9.4% $8% £12% £11% $8% Company A Company B £12% B’s net position is to borrow at $9.4% B saves $.6%

1.4% of $16 million financed with 1% of £10 million per year for 5 years. The swap bank makes money too: Swap Bank $9.4% $8% £12% £11% Company B $8% Company A £12% At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years. The swap bank faces exchange rate risk, but maybe they can lay it off in another swap.

Comparative Advantage as the Basis for Swaps
A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B A pays .4% less to borrow in pounds than B: A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds.

B has a comparative advantage in borrowing in £. B pays 2% more to borrow in dollars than A B pays only .4% more to borrow in pounds than A:

A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. If they borrow according to their comparative advantage and then swap, there will be gains for both parties.

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” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. For example, 6.60 — 6.85 means the swap bank will pay fixed-rate DM payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate DM payments at 6.85% against receiving dollar LIBOR.

Variations of Basic Currency and Interest Rate Swaps
Currency Swaps fixed for fixed fixed for floating floating for floating amortizing Interest Rate Swaps zero-for floating For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.

Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: Plain vanilla fixed for floating swap gets valued just like a bond. Currency swap gets valued just like a nest of currency futures.

Concluding Remarks The growth of the swap market has been astounding.
Swaps are off-the-books transactions. Swaps have become an important source of revenue and risk for banks

An Example of an Interest Rate Swap
Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense to for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at percent. Alternatively, firm B can raise the money by issuing 5-year FRNs at LIBOR + ½ percent. Firm B would prefer to borrow at a fixed rate.

The borrowing opportunities of the two firms are shown in the following table:

The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years Swap Bank 10 3/8% LIBOR – 1/8% Bank A

½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/ (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. Swap Bank 10 3/8% LIBOR – 1/8% Bank A 10%

The swap bank makes this offer to company B: You pay us 10 ½ % per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼% Company B

½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Here’s what’s in it for B: Swap Bank 10 ½% They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap. LIBOR – ¼% Company B LIBOR + ½%

The swap bank makes money too. ¼ % of $10 million = $25,000 per year for 5 years. Swap Bank 10 3/8 % 10 ½% LIBOR – ¼% LIBOR – 1/8% Bank A Company B LIBOR + ½% LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ /8 = 1/8 10% A saves ½ % B saves ½ %

The swap bank makes ¼ % Swap Bank 10 3/8 % 10 ½% LIBOR – ¼% LIBOR – 1/8% Bank A Company B LIBOR + ½% 10% Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD A saves ½ % B saves ½ %

Mid1 Answers (a) p72; (b) p101; © p79; (d) p83; (e) p93.
2. Borrow £; buy $ spot; invest $; sell $ forward. forward. For a starting sum of £ 10,000 covered interest arbitrage profit $ or £ 3. pp ; pp ;article on Law and Finance, pp p126, Annex 5A. Sell Tk. buy ¥; sell ¥ buy £; sell £ buy Tk. For a starting sum of Tk. 100,000 triangular arbitrage profit Tk 6. pp

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