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  • Financial Times March 4, 2005

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  • 1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-1 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fourth Edition 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. 06Chapter Six Interest Rate & Currency Swaps
  • 2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-2 Chapter Outline  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps  Variations of Basic Interest Rate and Currency Swaps  Risks of Interest Rate and Currency Swaps  Is the Swap Market Efficient?  Types of Swaps  Size of the Swap Market  The Swap Bank  Swap Market Quotations  Interest Rate Swaps  Currency Swaps
  • 3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-3  CHAPTER 5 INTRODUCED forward contracts as a vehicle for hedging exchange rate risk; chapter 7 introduced futures and options contracts on foeign exchange as alternative tools to hedge foreign exchange exposure. These types of instruments seldom have terms longer than a few years, however.  In this chapter, we examine interest rate swaps, both single-currency and cross-currency, which are techniques for hedging long-term interest rate risk and foreign exchange risk.
  • 4. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-4  The chapter begins with some useful definitions that define and distinguish between interest rate and currency swaps. Data on the size of the interest rate and currency swap markets are presented.  The next section illustrates the usefulness of interest rate swaps. The following section illustrates the construction of currency swaps.  The chapter also details the risks confronting a swap dealer in maintaining a portfolio of interest rate and currency swaps and shows how swaps are priced.
  • 5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-5 Types of Swaps  In interest rate swap financing, two parties, called counterparties, make a contractual agreement to exchange cash flows at periodic intervals.  There are two types of interest rate swaps. One is a single-currency interest rate swap. The name of this type is typically shortened to interest rate swap. The other type can be called a cross- currency interest rate swap. This type is usually just called a currency swap.
  • 6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-6 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.
  • 7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-7 “Plain vanilla” fixed-for-floating swaps interest rate swaps.  In the basic fixed-for-floating rate interest rate swap, one counterparty exchanges the interest payments of a floating-rate debt obligation for the fixed-rate interest payments of the other counterparty. Both debt obligations are denominated in the same currency. Some reasons for using an interest rate swap are to better match cash flows(inflows and outflows) and/or to obtain a cost savings. There are many variants of the basic interest rate swap, some of which are discussed below.
  • 8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-8 Currency swap  In a currency swap, one counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty denominated in another currency.  The basic currency swap involves the exchange of fixed- for-fixed rate debt service. Some reasons for using currency swaps are to obtain debt financing in the swapped denomination at a cost savings and/or to hedge long-term foreign exchange rate risk. The International Finance in Practice box “The World Bank’s First Curreny Swap” discusses the first currency swap.
  • 9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-9 The World Bank’s First Currency Swap  The World Bank frequently borrows in the national capital markets around the world and in the Eurobond market. It prefers to borrow currencies with low nominal interest rates, such as the deutsche mark and the Swiss franc. In 1981, the World Bank was near the official borrowing limits in these currencies but desired to borrow more. By coincidence, IBM had a large amount of deutsche mark and Swiss franc debt that it had incurred a few years ealier.  The proceeds of these borrowings had been converted to dollars for corporate use. Salomon Brothers convinced the World Bank to issue Eurodollar debt with maturities matching the IBM debt in other to enter into a currency swap with IBM.
  • 10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-10  IBM agreed to pay the debt service (interest and principal) on the World Bank’s Eurodollar bonds, and in turn the World Bank agreed to pay the debt service on IBM’s deutsche mark and Swiss franc debt. While the details of the swap were not made public, both counterparties benefited through a lower all-in cost (interest expense, transaction costs, and services charges) than they otherwise would have had. Additionally, the World Bank benefited by developing an indirect way to obtain desired currencies without going directly to the German and Swiss capital markets.
  • 11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-11  www.isda.org  This is the website of the International Swaps and derivatives association, Inc.  As the International Finance in Practice box suggests, the market for currency swaps developed first. Today, however, the interest rate swap market is larger. Exhibit 6.1 provides some statistics on the size and growth in the interest rate and currency swap markets. Size is measured by notional principal, a reference amount of principal for determining interest payments. Size of the Swap Market
  • 12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-12 Exhibit 6.1 Size of Interest Rate size of interest rate and currency swap markets: Total Notional Principal Outstanding Amounts in Billions of U.S. Dollars Year Interest Rate Swaps Currency Swaps 1995 12,811 1,197 1996 19,171 1,560 1997 22,291 1,824 1998 36,262 2,253 1999 43,936 2,444 2000 48,768 3,194 2001 58,897 3,942 2002 79,120 4,503 2003 111,209 6,371 2004(mid-year) 125,570 7,033
  • 13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-13  The exhibit indicates that both markets have grown significantly since 1995, but that the growth in interest rate swaps has been by far more dramatic. The total amount of interest rate swaps outstanding increased from $12,811 billion at year-end 1995 to $127.6 trillion by mid-year 2004, an increase of nearly 900 percent. Total outstanding currency swaps increased 488 percent, from $1,197 billion at year-end 1995 to over $7 trillion by mid-year 2004.
  • 14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-14 Size of the Swap Market  In 2004 the notational principal of: Interest rate swaps was $127,570 billion USD. Currency swaps was $7,033 billion USD  The most popular currencies are:  U.S. dollar  Japanese yen  Euro  Swiss franc  British pound sterling
  • 15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-15 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.
  • 16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-16 Swap market Quotations  Swap banks will tailor the terms of interests rate and currency swaps to customers’ needs. They also make a market in generic “plain vanilla” swaps and provide current market quotations applicable to counterparties with Aa or Aaa credit ratings.  Consider a basic U.S. dollar fixed-for- floating interest rate swap indexed to dollar LIBOR. A swap bank will typically quote a fixed- rate bid-ask spread (semiannual or annual ) versus three-month or six- month dollar LIBOR flat, that is , no credit premium.  Suppose the quote for a five-year swap with semiannual payments is 8.50-8.60 percent against six-month LIBOR flat. This means the swap bank will pay semiannual fixed-rate dollar payments of 8.50 percent against receiving six-month dollar LIBOR, or it will receive semiannual fixed-rate dollar payments at 8.60 percent against paying six-month dollar LIBOR.
  • 17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-17 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.
  • 18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-18 Interest Rate Swap Quotations Euro-€ £ Sterling Swiss franc U.S. $ Bid Ask Bid Ask Bid Ask Bid Ask 1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57 2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94 3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13 4 year 3.06 3.09 5.12 5.17 1.73 1.81 4.25 4.28 5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39 6 year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50 7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58 8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66 9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72 10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79 3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR
  • 19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-19 Basic Interest Rate Swaps  EXAMPLE 6.2  As an example of a basic interest rate swap, consider the following example of a fixed-for-floating rate swap. Bank A is a AAA-rated international bank located in the United Kingdom. The bank needs $10,000,000 to finance floating-rate Eurodollar term loans to its clients.  It is considering issuing five-year floating-rate notes(FRNs) indexed to LIBOR. Alternatively, the bank could issue five-year fixed-rate Eurodollar bonds at 10 percent.  The FRNs make the most sense for bank A, since it would be using a floating-rate liability to finance a floating-rate asset. In this manner, the bank avoids the interest rate risk associated with a fixed-rate issue.
  • 20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-20  Company B is a BBB-rated U.S. company. It needs $10,000,000 to finance a capital expenditure with a five-year economic life. It can issue five-year fixed-rate bonds at a rate of 11.5 percent in the U.S. bond market . Alternatively, it can issue five-year FRNs at LIBOR plus.50 percent.  The fixed-rate debt makes the most sense for company B because it locks in a financing cost. The FRN alternative could prove very unwise should LIBOR increase substantially over the life of the note, and could possibly result in the project being unprofitable.  A swap bank familiar with the financing needs of bank A and Company B has the opportunity to set up a fixed-for-floating interest rate swap that will benefit each counterparty and the swap bank. Assume that the swap bank is quoting five-year U.S. dollar interest rate swaps at 10.375-10.50 percent against LIBOR flat.
  • 21. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-21 The key, or necessary condition, giving rise to the swap is that a quality spread differential (QSD) exists. A QSD is the difference between the default-risk premium differential on the fixed-rate debt and the default-risk premium differential on the floating-rate debt. In general, the former is greater than the latter. Financial theorists have offered a variety of explanations for this phenomenon, none of which is completely satisfactory. Given that a QSD exists, it is possible for each counterparty to issue the debt alternative that is least advantageous for it, then swap interest payments, such that each counterparty ends up with the type of interest payment desired, but at a lower all-in cost than it could arrange on its own. EXHIBIT 6.2 Calculation of Quality Spread Differentia Company B Bank A Differential Fixed-rate 11.25% 10.00% 1.25% Floating-rate LIBOR+.50% LIBOR .50% QSD=.75%
  • 22. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-22  EXHIBIT 6.2 diagrams a possible scenario the swap bank could arrange for the two counterparties.  From Exhibit 6.2, we see that the swap bank has instructed company B to issue FRNs at LIBOR plus .50 percent rather than the more suitable fixed-rate debt at 11.25 percent. Company B passes through to the swap bank 10.50% and receives LIBOR in return.  In total, Company B pays 10.50% (to the swap bank) plus LIBOR+.50% (to the floating-rate bondholders) and receives LIBOR percent (from the swap bank) for an all-in cost of 11%.  10.50%+LIBOR+.50% - LIBOR=11%  Thus, through the swap, Company B has converted floating-rate debt into fixed-rate debt at an all-in cost .25% lower than the 11.25% fixed rate it could arrange on its own.
  • 23. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-23  Similarly, Bank A was instructed to issue fixed-rate debt at 10% rather than the more suitable FRNs. Bank A passes through to the swap bank LIBOR and receives 10.375% in return.  In total, Bank A pays 10% (to the fixed-rate Eurodollar bondholders) plus LIBOR%( to the swap bank) and receives 10.375%(from the swap bank) for an all-in cost of LIBOR - .375%.  10%+LIBOR - 10.375%=LIBOR - .375%  Through the swap, Bank A has converted fixed-rate debt into floating-rate debt at an all-in cost .375% lower than the floating rate of LIBOR it could arrange on its own.  The swap bank also benefits because it pays out less than it receives from each counterparty to the other counterparty .It receives 10.50% (from Company B)+LIBOR (from Bank A) and pays 10.375%(to Bank A) and LIBOR (to Company B). The net inflow to the swap bank is .125%.
  • 24. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-24 EXHIBIT 6. 3 Fixed-for-floating interest rate Swap Issue Eurodollar bonds @10% Bank A AAA U.K. Issue FRNs in $ @LIBOR Issue domestic Bonds @11.25% Company B BBB U.S. Issue FRNs in $ @LIBOR+.50% Swap Bank LIBOR LIBOR 10.375% 10.50%
  • 25. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-25 Net Cash out Flows Bank A Swap Bank Company B Pays LIBOR 10% 10.375% LIBOR 10.50% LIBOR+.50% Receives -10.375% -10.50% -LIBOR -LIBOR Net LIBOR-.375% -.125% 11%
  • 26. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-26 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. and 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.
  • 27. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-27 An Example of an Interest Rate Swap 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 11.75 percent.  Alternatively, firm B can raise the money by issuing 5- year floating-rate notes at LIBOR + ½ percent.  Firm B would prefer to borrow at a fixed rate.
  • 28. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-28 An Example of an Interest Rate Swap The borrowing opportunities of the two firms are: Company B Bank A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR
  • 29. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-29 An Example of an Interest Rate Swap 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 COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR Swap Bank LIBOR – 1/8% 10 3/8% Bank A
  • 30. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-30 COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR An Example of an Interest Rate Swap Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. 10% ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Swap Bank LIBOR – 1/8% 10 3/8% Bank A
  • 31. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-31 An Example of an Interest Rate Swap Company B The swap bank makes this offer to company B: You pay us 10½% 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 BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR
  • 32. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-32 COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR An Example of an Interest Rate Swap 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. LIBOR + ½% Here’s what’s in it for B: ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank Company B 10 ½% LIBOR – ¼%
  • 33. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-33 An Example of an Interest Rate Swap The swap bank makes money too. ¼% of $10 million = $25,000 per year for 5 years. LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼ Swap Bank Company B 10 ½% LIBOR – ¼%LIBOR – 1/8% 10 3/8% Bank A COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR
  • 34. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-34 An Example of an Interest Rate Swap Swap Bank Company B 10 ½% LIBOR – ¼%LIBOR – 1/8% 10 3/8% Bank A B saves ½%A saves ½% The swap bank makes ¼% COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR
  • 35. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-35  A Basic Currency Swap  As an example of a basic currency swap, consider the following example.  A U.S. MNC desire to finance a capital expenditure of its German subsidiary.The project has an economic life of five years. The cost of the project is €40,000,000. At the currency exchange rate of $1.30/€1, the parent firm could raise $52,000,000 in the U.S. capital market by issuing five-year bonds at 8%. The parent would then convert the dollars to euros to pay the project cost.  The German subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the pricipal in five years.  The only problem with this situation is that a long-term transaction exposure is created. If the dollar approciates substantially against the euro over the loan period, it may be difficult for the German subsidiary to earn enough in euros to service the dollar loan. An Example of a Currency Swap
  • 36. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-36  An alternative is for the U.S. parent to raise €40,000,000 in the international bond market by issuing euro- denominated Eurobonds. (The U.S. parent might instead issue euro-denomonated foreign bonds in the German capital market.) However, if the U.S. MNC is not well known, it will have difficulty borrowing at a favorable rate of interest. Suppose the U.S. parent can borrow €40,000,000 for a term of five years at a fixed rate of 7%. The current normal borrowing rate for a well-known firm of equivalent creditworthiness is 6%.
  • 37. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-37  Assume a German MNC of equivalent creditworthiness has a mirror- image financing need.It has a U.S. subsidiary in need of $52,000,000 to finance a capital expenditure with an economic life of five years. The German parent could raise €40,000,000 in the German bond market at a fixed rate of 6% and convert the funds to dollar to finance the expenditure. Transaction exposure is created, however, if the euro appreciates substantially against the dollar. In this event, the U.S. subsidiary might have difficulty earning enough in dollars to meet the debt service. The German parent could issue Eurodollar bonds, but since it is not well known its borrowing cost would be , say , a fixed rate of 9%.
  • 38. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-38  A swap bank familiar with the financing needs of the two MNCs could arrange a currency swap that would solve the double problem of each MNC, that is, be confronted with long-term transaction exposure or borrow at a disadvantageous rate. Ths swap bank would instruct each parent firm to raise funds in its national capital market where it is well known and has a comparative advantage because of name or brand recognition. Then the pricinpal sums would be exchanged through the swap bank.  Annually, the German subsidiary would remit to its U.S. parent €2,400,000 in interest (6% of €40,000,000 ) to be passed through the swap bank to the German MNC to meet the euro debt service. The U.S. subsidiary of the German MNC would annually remit $4,160,000 in interest (8% of $ 52,000,000) to be passed through to the swap bank to the U.S. MNC to meet the dollar debt service.
  • 39. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-39  At the debt retirement date, the subsidiaries would remit the pricipal sums to their respective parents to be exchanged through the swap bank in order to pay off the bond issues in the national capital markets.  Exhibit 6.4 demonstrates that there is a cost savings for each counterparty because of their relative comparative adavntage in their respective national capital markets.  The U.S. MNC borrows euro at an all-in-cost (AIC) of 6 percent through the currency swap instead of the 7% it would have to pay in the Eurobond market.  The German MNC borrows dollars at an AIC of 8% through the swap instead of the 9% rate it would have to pay in the eurobond market.
  • 40. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-40 EXHIBIT 6.4 $/ € Currency Swap U.S. Capital market @8% U.S. MNC Euro-denominated Eurobond market @7% German Capital market @6% German MNC Eurodollar Eurobond market @9% Swap Bank €@6% €@6% $@8% $@8%
  • 41. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-41 An Example of a Currency Swap  Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant.  They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.  This will give them exchange rate risk: financing a sterling project with dollars.  They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.
  • 42. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-42 An Example of a Currency Swap  If they can find a British MNC with a mirror- image financing need they may both benefit from a swap.  If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.
  • 43. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-43 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 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. $ £ Company A 8.0% 11.6% Company B 10.0% 12.0%
  • 44. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-44 $9.4% An Example of a Currency Swap $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% Firm B $8% £12% Swap Bank Firm A £11% $8% £12%
  • 45. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-45 An Example of a Currency Swap $8% £12% $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% Firm B Swap Bank Firm A £11% $8% $9.4% £12% A’s net position is to borrow at £11% A saves £.6%
  • 46. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-46 An Example of a Currency Swap $8% £12% $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% Firm B Swap Bank Firm A £11% $8% $9.4% £12% B’s net position is to borrow at $9.4% B saves $.6%
  • 47. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-47 An Example of a Currency Swap $8% £12% $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% Firm B The swap bank makes money too: At S0($/£) = $1.60/£, that is a gain of $64,000 per year for 5 years. The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap). 1.4% of $16 million financed with 1% of £10 million per year for 5 years. Swap Bank Firm A £11% $8% $9.4% £12% $64,000 $224,000 –$160,000
  • 48. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-48 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.  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.
  • 49. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-49 A is the more credit-worthy of the two firms. Comparative Advantage as the Basis for Swaps $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in pounds. A pays 2% less to borrow in dollars than B A pays .4% less to borrow in pounds than B:
  • 50. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-50 B has a comparative advantage in borrowing in £. Comparative Advantage as the Basis for Swaps $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% B pays 2% more to borrow in dollars than A B pays only .4% more to borrow in pounds than A:
  • 51. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-51 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. Comparative Advantage as the Basis for Swaps
  • 52. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-52 Risks of Interest Rate and Currency Swaps  Some of the major risks that a swap dealer confronts are discussed here.  Interest-rate risk refers to the risk of interest rates changing unfavorably before the swap bank can lay off on an opposing counterparty the other side of an interest rate swap entered into with a counterparty.  As an illustration, reconsider the interest rate swap example, Example 6.1. To recap, in that example, the swap bank earns a spread of .125%. Company B passes through to the swap bank 10.50% per annum (0n the notional principal of $10,000,000) and receives LIBOR percent in return. Bank A passes through to the swap LIBOR percent and receives 10.375% in return. Suppose the swap
  • 53. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-53  Suppose the swap bank entered into the position with Company B first. If fixed rate increase substantially, say, by .50%, Bank A will not be willing to enter into the opposite side of the swap unless it receives, say, 10.875%. This would make the swap unprofitable for the swap bank.  Basis risk refers to a situation in which the floating-rates of the two counterparties are not pegged to the same index.Any difference in the indexes is known as the basis.For example, one counterparty could have its FRNs pegged to LIBOR, while the other counterparty has its FRNs pegged to the U.S. Treasury bill rate. In this event, the indexes are not perfectly positively correlated and the swap may periodically be unprofitable for the swap bank. In our example, this would occur if the Treasury bill rate was substantially larger than LIBOR and the swap bank receives LIBOR from one counterparty and pays the treasury bill rate to the other.
  • 54. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-54  Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes for the bank to lay off a swap it undertakes with one counterparty with an opposing counterparty.  Credit risk is the major risk faced by a swap dealer. It refers to the probability that a counterparty will default. The swap bank that stands between the two counterparties is not obligated to the defaulting counterparty, only to the nondefaulting counterparty. There is a separate agreement between the swap bank and each counterparty.  Mismatch risk refers to the difficulty of finding an exact opposite match for a swap the bank has agreed to take. The mismatch may be with respect to the size of the principal sums the counterparties need, the maturity dates of the individual debt issues, or the debt service dates.
  • 55. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-55  Sovereign risk refers to the probability that a country will impose exchange restrictions on a currency involved in a swap. This may make it very costly, or perhaps impossible, for a counterparty to fulfill its obligation to the deale. In this event, provisions exist for terminating the swap, which results in a loss of revenue for the swap bank.  To facilitate the operation of the swap market, the International Swaps and Derivatives Association (ISDA) has standardized two swap agreements. One is the “Interest Rate and Currency Exchange Agreement” that covers currency swaps, and the other is the “Interest Rate Swap Agreement” that lays out standard terms for U.S.-dollar- denominated interest rate swaps. The standardized agreements have reduced the time necessary to establish swaps and also provided terms under which swaps can be terminated early by a counterparty.
  • 56. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-56 Geithner Urges Tighter Regulation of Complex InvestmentsBy VOA News 14 May 2009  Treasury Secretary Timothy Geithner says complex financial instruments called derivatives should be bought and sold with less secrecy and more regulation. The lightly regulated derivatives market is valued in the trillions of dollars. Some derivatives were intended as a kind of insurance to reduce the risk of large and complex transactions. But instead, in some cases, these instruments played a role in the collapse of major financial firms and the start of the current economic crisis. Late Wednesday, Geithner proposed that derivatives be traded on regulated exchanges and that they be backed by a certain amount of capital in case of default. The idea must be considered and approved by Congress and the President before it can become law.
  • 57. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-57
  • 58. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-58 End Chapter Six