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interest rate and currency swaps
1. Interest rate and currency swaps
When multinationals face interest
rate risk, they adopt these strategies
2. 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
– Single currency interest rate swap (interest rate
swap)
– Cross-currency interest rate swap (currency swap)
3. Interest rate swap
• A plain vanilla IRS
– A fixed-for-floating rate swap
• A quality spread differential (QSD) is the
difference between default-risk premium
differential on the fixed-rate debt and the
default-free risk premium differential on
floating-rate debt.
4. Calculation of QSD
Company B Bank A Differential
Fixed-rate 11.25% 10.00% 1.25%
Floating-rate LIBOR + 0.50% LIBOR 0.50%
QSD 0.75%
5. Fixed-for-floating IRS
Issue Eurodollar
Bonds @ 10%
BANK A
AAA
UK
Issue FRN in $
@ LIBOR - 0.375%
Swap Bank
Company B
BBB
US
=
=
10.375% 10.50%
LIBOR LIBOR
10%
Issue domestic
Bonds @ 11%
Issue FRN in $
@ LIBOR + 0.50%
Company B Bank A Differential
Fixed-rate 11.25% 10.00% 1.25%
Floating-rate LIBOR + 0.50% LIBOR 0.50%
QSD 0.75%
6. Currency Swap
German MNC US MNC Differential
Dollar loan 9% on $ 8% $ 1%
Euro loan 6% on Euro 7% Euro 1%
2%
In interest rate swap, we took the difference of difference; here we are taking
addition of difference.
7. • The process of a currency swap is the
following:
– At beginning, exchange principals
– At the end of each period, exchange interest for
the borrowed currency
– At the end of the swap, return principals
8. Currency Swap (principals exchanged)
US
Capital Market
USD loan @ 8%
US
MNC
Swap Bank
German
Capital market
Euro loan @ 6%
German
MNC
$ 1 mln
€ 0.8 mln € 0.8 mln
$1mln
Issue bond
Receive E0.8 mln
$1mln
Spot rate: E0.80/$
Issue bond
€ 0.8 mln
German company
In US
US company in
Germany
9. Currency Swap (interest payments)
US
Capital Market
USD loan @ 8%
US
MNC
Swap Bank
German
Capital market
Euro loan @ 6%
German
MNC
$ @ 8% on 1mln
€ @ 6.10% € @ 6% on 0.8 mln
$ @ 8.15%
10. Comparative Advantage: Example
Example
• Suppose the American and British companies have
access to both British (BP) and American ($)
lending markets.
• Suppose the American company is more
creditworthy and can obtain lower rates than the
British company in both the US and British
markets.
10
11. Comparative Advantage: Example
Example:
• Suppose the American company can obtain 10%
U.S. dollar-denominated loans in the U.S. market
and 7.25% sterling-denominated loans in the
British market, whereas the best the British
company can obtain is 11% in the U.S. market and
7.5% in the British market
11
12. 12
Comparative Advantage: Example
Loan Rates for American and British
Companies in Dollars and Pounds
Spot: E0 = $/£ = $1.50/£
Dollar Market
(rate on $)
Pound Market
(rate on £)
American Company
British Company
10%
11%
7.25%
7.5%
12
13. Example
• The American company has a comparative advantage in
the US market:
– It pays 1% less than the British company in the US
market, compared to only .25% less in the British
market.
• The British company has a comparative advantage in the
British market:
– It pays .25% more than the American company in the
British market, compared to 1% more in the US
market.
Comparative Advantage: Example
13
14. Comparative Advantage: Example
• When a comparative advantage exist, a swap
bank is in a position to benefit one or both
parties.
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15. Comparative Advantage: Example
Example:
• Suppose in this case a swap bank sets up the following
swap arrangement:
1. The American company borrows $150 million at
10%, and then agrees to swap it for £100 million
loan at 7%.
2. The British company borrows £100 million at
7.5%, and then agrees to swap it for $150 million
loan at 10.6%.
15
16. Comparative Advantage: Example
• The next three exhibit slides show the
initial swap of the principals, annual cash
flows of interest, and final exchange of the
principals.
16
17. Comparative Advantage: Example
17
(a) Initial Cash Flow
Bondholder
British
Company
British
AssetAmerican
s'CompanyBritish
m100£
Bondholder
American
Company
American
AssetBritish
s'CompanyAmerican
m150$Bank
Swap
m150$
m150$
m150$
m100£
m100£
m100£
18. Comparative Advantage: Example
18
(b) Annual Interest Cash flow
Bondholder
British
Company
British
AssetAmerican
s'CompanyBritish
£7m)07)(.m100(£
Bondholder
American
Company
American
AssetBritish
s'CompanyAmerican
Bank
Swap
m9.15$)150)($106(.
£7.5m)075)(.m100(£
£7.5m
m15$)m150)($10(.
£7.5m
m9.15$
m15$
19. Comparative Advantage: Example
19
(c) Principal Payment at Maturity
Bondholder
British
Company
British
AssetAmerican
s'CompanyBritish
m100£
Bondholder
American
Company
American
AssetBritish
s'CompanyAmerican
m150$Bank
Swap
m150$
m150$
m150$
m100£
m100£
m100£
20. Comparative Advantage:
Swap Bank’s Position
• In this swap arrangement:
– The American company benefits by paying 0.25%
less than it could obtain by borrowing British
pounds directly in the British market
– The British company gains by paying 0.4% less
than it could obtain directly from the U.S.
market.
20
21. Comparative Advantage:
Swap Bank’s Position
• The swap bank in this case will receive $15.9 million
each year from the British company, while only
having to pay $15 million to the American company,
for a net dollar receipt of $ 0.9 million.
• On the other hand, the swap bank will receive only
£7 million from the American company, while having
to pay £7.5 million to the British company, for a net
sterling payment of £0.5 million.
21
22. Comparative Advantage:
Swap Bank’s Position
Swap Bank’s Position:
22
Swap Bank’s $ Position
Receives: (.106)($150,000,000) = $15,900,000
Pays: −(.10)($150,000,000) = −$15,000,000
Net $ Receipt: $900,000
Swap Bank’s £ Position
Receives: (.07)(£100,000,000) = £7,000,000
Pays: (.075)(£100,000,000) = −£7,500,000
Net £ Payment: −£500,000
23. Comparative Advantage:
Swap Bank’s Position
• Thus, the swap bank has a position equivalent to a
series of long currency forward contracts in which it
agrees to buy £500,000 for $900,000 each year. The
swap bank's implied forward rate on each of these
contracts is $1.80/£:
23
£
80.1$
000,500£
000,900$
Ef
24. Comparative Advantage:
Swap Bank’s Position
• The swap bank can hedge its position with currency
forward contracts.
• If the forward rate is less than $1.80/£, then the
bank could gain from hedging the swap agreement
with forward contracts to buy £500,000 each year
each year for the next five years.
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25. Comparative Advantage:
Swap Bank’s Position
• For example, suppose the yield curves applicable for the swap bank are flat at 9.5% in the
U.S. dollars and 7% in pounds (assume annual compounding). Using the interest rate
parity relation, the one-, two-, three-, four-, and five-year forward exchange rates would
be:
25
T
BP
$
0fT
R1
R1
EE
£/683616.1$
07.1
095.1
)£/50.1($E:5T
£/645177.1$
07.1
095.1
)£/50.1($E:4T
£/607616.1$
07.1
095.1
)£/50.1($E:3T
£/570912.1$
07.1
095.1
)£/50.1($E:2T
£/535047.1$
07.1
095.1
)£/50.1($E:1T
5
f
4
f
3
f
2
f
1
f
26. Comparative Advantage:
Swap Bank’s Position
• The swap bank could enter into forward contracts to
buy £500,000 each year for the next five years at these
forward rates.
• With all of the forward rates less than implied forward
rate of $1.80/£, the bank’s dollar costs of buying
£500,000 each year would be less than its $900,000
annual inflow from the swap.
• By combining its swap position with forward contracts,
the bank would be able to earn a total profit from the
deal of $478,816.
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28. Comparative Advantage:
Swap Bank’s Hedge
• Instead of forward contracts, the swap bank also could hedge its swap
position by using a money market position.
• For example, on its first sterling liability of £500,000 due in one year, the
bank would need to create a sterling asset worth £500,000 one year later
(current value of £467,290M = £500,000/1.07) and a dollar liability worth
$764,524 (based on the forward contract).
• The bank could do this by borrowing $700,935 (= ($1.50/£) (£467,290)) at
9.5%, converting it to £467,290, and investing the sterling at 7% interest for
the next year.
• One year later, the bank would have £500,000 (= £467,290(1.07)) from the
investment to cover its sterling swap liability and would have a dollar
liability of $767,524 (= $700,935(1.095)), which is less than the $900,000
dollar inflow from the swap.
• The bank would thus earn a profit of $132,476 (= $900,000 −$767,524)
from the hedged cash flow – the same profit it would earn from hedging
with the forward exchange contracts if the interest rate parity relation
holds.
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29. Summary
• The presence of comparative advantage creates a currency
swap market in which swap banks look at the borrowing rates
offered in different currencies to different borrowers and at the
forward exchange rates and money market rates that they can
obtain for hedging.
• Based on these different rates, they will arrange swaps that
provide each borrower with rates better than the ones they
can directly obtain and a profit for them that will compensate
them for facilitating the deal and assuming the credit risk of
each counterparty.
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