Lecture 9: Interest Rate Exposure and Swaps

Chapter 9: Interest Rate Exposure and Swaps Motivation & Definition Types of Interest Rate Risk Sources of Interest Rate Risk Managing Interest Rate Risk • Refinancing • FRAs • Futures • Options • Swaps More on Swaps • Types • Valuation Exercises: All

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Interest Rate Exposure Interest rate exposure is not unique to international finance or MNEs, but it is more complex when we have multiple currencies. • We’ll review the basics, then expand the discussion to multiple currencies. Interest Rate Exposure: Sensitivity of firm’s cashflow (or value) to changes in interest rates. The firm may have liabilities linked to interest rates. • ongoing cashflows (loan repayments, coupon payments, sinking funds, etc.) • sometimes capitalized into lump sums (retiring or restructuring debt.) Exhibit 9.1: A note on the calculation of interest payments. The firm may have assets linked to interest rates. • it may hold bonds, make loans, etc. • Banks do both (deposits = liabilities, loans = assets.) Benchmarks: Prime Rate, Fed Funds Rate, LIBOR, t-bill auction yields, etc.

Revision Date: November 6, 2001

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Lecture 9: Interest Rate Exposure and Swaps

Types of Interest Rate Exposure Repricing Risk: Caused by changes in benchmark rates. Credit Risk: Caused by changes in interest rate charged relative to benchmark. • Usually due to changes in perceived creditworthiness (e.g. credit rating upgrades/downgrades) • In worst case, credit may not be available at any price. Counterparty Risk: Risk that a given counterparty defaults. • strong argument for lenders to diversify portfolio. • strong argument for using exchange-traded derivatives (Clearinghouse Corp.) • limited in swaps by right of offset (as we’ll see) Basis Risk: Risk that interest rate spreads will change. • common risk for financial institutions Banks borrow short at deposit rates, lend long at commercial loan & mortgage.

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Examples of Interest Rate Exposure Strategy 1: Borrow $1 M for 3 yr. at fixed i%. • no exposure (unless we change our minds in mid-loan.) Strategy 2: Borrow $1 M for 3 yr. at prime + 2%, reset annually • no credit risk, but pricing risk Strategy 3: Borrow $1 M for 1 yr at fixed i%, then refinance • both credit & repricing risks, but flexible in cost and amounts Exhibit 9.3 - Puebla Corp. Floating rate loans are the single largest & most common source of i.r. exposure. 3 year loan of $10 M, floating rate reset annually, with 1.5% fee up-front. • Strategy 2 • Up-front fee increases effective cost of funds to over 7% AIC (all-in costs) of the loan simply calculated as IRR of cashflows.

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Managing the Interest Rate Exposure - Refinancing Simplest way is to borrow fixed rate instead of floating (Duh!) Many lenders don’t like to do this since their cost of funds is floating.

Will it be cheaper to pay a premium to a lender for a fixed cost of funds? Or to use derivatives to cover all the interest rate risk? see Modigliani & Miller.

Revision Date: November 6, 2001

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Lecture 9: Interest Rate Exposure and Swaps

Managing the Interest Rate Exposure - FRAs Forward Rate Agreement: Like a forward fx contract, but for two interest rates rather than currencies Counterparties fix a maturity, interest rate and (notional) principal. Seller pays the buyer the difference between the benchmark interest rate (e.g. LIBOR) and the agreed rate. • payments scaled by notional principal. • Seller pays buyer if LIBOR higher, buyer pays seller if LIBOR lower. Traded in interbank market, maturities typically < 1 yr., most major currencies. An FRA buyer with floating rate debts faces the same net cashflow as if she had fixed rate debt. • payments from FRA seller offset any rise in debt service • payments to FRA seller offset any fall in debt service Problems with market access, maturity, currency may limit application.

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Managing the Interest Rate Exposure - Futures Futures are based on the price to pay now to get benchmark (e.g. LIBOR) on a 1Q deposit paying $1 M at a future date. Exhibit 9.4 shows pricing, expressed as 100 - interest rate. Unlike FRAs, futures are liquid, exchange-traded, long-maturity, marked to market. • Each percentage point is worth 0.01 x $1 M x 90/360 = $2,500. Interest rate futures can be used like FRAs Profits & losses on futures contracts offset those on a specific interest payment. • we’ll avoid going into the details of FRA pricing • remember that higher interest rates make FRA prices fall (& vice-versa) Exhibit 9.5 shows how to use Futures to hedge exposure. Paying floating rate means we hedge by selling futures. Receiving means we hedge by buying futures. Revision Date: November 6, 2001

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Lecture 9: Interest Rate Exposure and Swaps

Managing the Interest Rate Exposure - Options In practice, interest rate options (and often quite complex ones) are used to manage interest rate risk in the real world.

We’re not going to talk about how to price interest rate options.

Like the instruments we’ve talked about, the options effectively promise to offset the cost to the buyer of falls/rises in interest rates beyond certain thresholds (caps, floors). • collars cover the results of interest rates moving out of a given range. See Chapter 24.

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Managing the Interest Rate Exposure - Swaps Swaps are the biggest single category of interest rate derivatives globally. They are also the most closely linked to international finance and MNEs. • We saw these briefly in Ch. 7 - Operating Exposure These are not the swaps we talked about in the context of forward fx rates. Those provided for a single spot fx transaction now and a single forward fx transaction (same amount, opposite direction) at maturity. For the rest of this lecture, a swap will refer to an agreement to exchange a series of regularly-sized periodic payments. • cashflows look just like bonds (coupons & perhaps principal at maturity) • however, the two bonds may differ in various ways (as we’ll see).

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Types of Swaps Interest Rate Swap: Exchange a stream of fixed payments for a payment stream linked to a floating interest rate. • a.k.a. coupon swap, plain-vanilla swap, fixed for floating swap See Exhibit 9.7 for Puebla Corp. example. • just swaps out the LIBOR portion; left with fixed rate + points • you don’t pay points on swaps; right of offset reduces credit risk Currency Swap: Exchange a stream of payments in one currency for a payment stream in another currency. • Either stream could be fixed interest rate, or floating • Exhibit 9.8 shows the possible combinations See Exhibit 9.9 for Puebla Corp. example. • swap fixed USD for fixed CHF • unlike interest rate swap, we now also exchange principal at maturity. • current spot rate converts all payment streams

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

A Brief Digression on Other Uses of Swaps While most companies have debt, this debt is usually not liquid. Swaps allow transformation of this debt, as if it were liquid. Arbitrage of differing international perceptions Suppose you’re well known in the EU, but not in Asia. This means you can raise funds more cheaply in EUR (LIBOR + 50 bp) than in Asian currencies (LIBOR + 150 bp). • Asian banks don’t know you, your European banks only want to lend EUR So borrow in EUR, swap into JPY etc., enjoy LIBOR + 50 bp in JPY. Transformation of Subsidized Financing Air Canada can get CAD loan guarantees, but needs USD for financing, fuel. • borrow CAD cheap due to loan guarantees • swap into USD, benefit from reduced interest rate

Revision Date: November 6, 2001

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Lecture 9: Interest Rate Exposure and Swaps

Valuing Swaps Swaps allow us to exchange two cashflows that currently have the same PV. However, changes in interest rates, exchange rates, will change this. • one side will gain from swap, the other will lose. Link between expected movements and risk strategy (Exhibit 9.7) Suppose we have fixed rate debt • if we expect rates to rise, sit back and enjoy! • if we expect rates to fall, swap into floating rate Suppose we have floating rate debt • if we expect rates to fall, sit back and enjoy! • if we expect rates to rise, swap into fixed rate Suppose we have domestic currency debt • if we expect our currency to depreciate, sit back and enjoy! • if we expect our currency to appreciate, swap repayment into weaker currency.

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 9: Interest Rate Exposure and Swaps

Valuing Swaps (cont.) In the future, our financing needs may change and we may want to unwind our swap positions. This means that we “exchange” the remaining cashflows again. • We give up the flows we were to receive. • Counterparty gives up the flows we were to pay. Problem: Changes in interest rates, exchange rates mean these two are probably no longer equal in value. • Require a side payment to unwind the swap. • Payment represents difference in market value of two swap legs (e.g. payment stream and receipt stream.) See spreadsheet for example of how to calculate.

Revision Date: November 6, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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