IBUS 700 Cross-Currency and Interest Rate Swaps

Professor Robert Hauswald Kogod School of Business, AU 10/11/2007

Global Risk Management Techniques - © Robert B.H. Hauswald

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XFX and Interest Rate Swaps • Plain-vanilla swaps: FI risk management – 2 segments: FX and interest rate swaps – principle: match exposures and positions

• Generally applicable risk management ideas: – build risk management into strategies – second chance: deal with risks after the fact

• “Divide and conquer”: repackaging risks – ex ante: lower your borrowing costs – ex post: repackage your risks 10/11/2007

Global Risk Management Techniques - © Robert B.H. Hauswald

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Borrowers’ Objectives • Lower your funding costs: optimal distribution of risks between parties – look at the project from your lenders’ perspective

• Default risk: problematic since almost unhedgeable – – – –

use the particular structure of investments: collateral Credit Default Swaps: limited number of liquid names guarantee: only as good as the guarantor lender bears cost: spread over benchmark

• Two easily hedged risks: FX and interest – use hedge to lower your borrowing costs! 10/11/2007

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Interest and FX Rate Outlook, Bond Pricing and Issuing • Analyze FX and interest rate environment – by statistical methods, market analysis – reconcile your own opinion with funding needs

• Levels: security type and structure – high interest rates: floating – low interest rate: fixed or capped floating

• Volatility: segment, deal type and timing – low volatility: little advantage in repackaging – high volatility: funding arbitrage, swaps

• Risk management includes “good judgement” 10/11/2007

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Basic Toolkit • A&L matching: offsetting risks on balance sheet – one party’s risk might be the other’s opportunity – trading off risks: FX and default, FX and interest

• Fixed income security structure: distributes risks – embedded options: call (prepayment) or put rights – coupon: fixed or floating

• Derivatives: re-package original financing with – swaps: FX, interest rate or FX-interest rate swaps – options (insurance) : FX, yield (interest rate) – embedded options: structure of bond 10/11/2007

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Swap Fundamentals • In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals – exchange of cash flows – contractually fixed: dates, size, obligation

• Single currency interest rate swap: – “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps

• Cross-Currency interest rate swap – currency swap; fixed for fixed rate debt service in two (or more) currencies 10/11/2007

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Origin of Swap Markets • New phenomenon: 1970s and 1980s – currency transactions between central banks – first interest rate swap: 1982

• Causes: market segmentation – – – – –

financial arbitrage: comparative borrowing advantages tax and regulatory arbitrage risk management tool financial integration Future: adverse publicity vs. financial needs

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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

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Notional Amounts Outstanding: USD bn FX contracts

Interest rate contracts

Equity-linked contracts

Commodity contracts

Credit default swaps

300000

250000

200000

150000

100000

50000

Ju n.

19 98 ec .1 99 8 Ju n. 19 9 9 D ec .1 99 9 Ju n. 20 00 D ec .2 00 0 Ju n. 20 01 D ec .2 00 1 Ju n. 20 02 D ec .2 00 2 Ju n. 20 03 D ec .2 00 3 Ju n. 20 0 4 D ec .2 00 4 Ju n. 20 05 D ec .2 00 5 Ju n. 20 06 D ec .2 00 6

0

D

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Gross Market Value : USD bn FX contracts

Interest rate contracts

Equity-linked contracts

Commodity contracts

Credit default swaps

7000 6000 5000 4000 3000 2000 1000

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Ju n.

19 98 ec .1 99 8 Ju n. 19 99 D ec .1 99 9 Ju n. 20 00 D ec .2 00 0 Ju n. 20 01 D ec .2 00 1 Ju n. 20 02 D ec .2 00 2 Ju n. 20 03 D ec .2 00 3 Ju n. 20 04 D ec .2 00 4 Ju n. 20 05 D ec .2 00 5 Ju n. 20 06 D ec .2 00 6

0

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The Swap Bank • A swap bank is a financial institution that facilitates swaps between counterparties. • The swap bank (generic term) 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. 10/11/2007

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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.

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Interest Rate Swap Quotations Euro-€ Bid

Ask

£ Sterling Bid

Ask

Swiss franc

U.S. $

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

4 year

3.06

5 year

3.23

6 year

3.38

7 year

3.52

5.13 5.17 1.58 bank4.11 3.82–3.85 means1.50 the swap will 4.13 3.09 pay 5.12 5.17 euro 1.73payments 1.81 fixed-rate at4.25 3.82%4.28 3.26 against 5.11 receiving 5.16 1.93 2.01 4.37it will 4.39 euro LIBOR or 3.41 receive 5.11 fixed-rate 5.16 2.10 2.18 4.46at 4.50 euro payments 3.55 3.85% 5.10 against 5.15 receiving 2.25 2.33 4.55 4.58 euro LIBOR

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

3.85

5.08

5.13

2.56

2.64

4.75

4.79 13

10 10/11/2007 year 3.82

Global Risk Management Techniques - © Robert B.H. Hauswald

Fixed-Income Notionals: USD bn Forward rate agreements

Interest rate swaps

Options

250000

200000

150000

100000

50000

Ju n.

19 98 ec .1 99 8 Ju n. 19 99 D ec .1 99 9 Ju n. 20 00 D ec .2 00 0 Ju n. 20 01 D ec .2 00 1 Ju n. 20 02 D ec .2 00 2 Ju n. 20 03 D ec .2 00 3 Ju n. 20 04 D ec .2 00 4 Ju n. 20 05 D ec .2 00 5 Ju n. 20 06 D ec .2 00 6

0

D

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Global Risk Management Techniques - © Robert B.H. Hauswald

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F-Inc Gross Market Value : USD bn Forward rate agreements

Interest rate swaps

Options

7000 6000 5000 4000 3000 2000 1000

Ju n.

19 98 D ec .1 99 8 Ju n. 19 99 D ec .1 99 9 Ju n. 20 00 D ec .2 00 0 Ju n. 20 0 1 D ec .2 00 1 Ju n. 20 02 D ec .2 00 2 Ju n. 20 03 D ec .2 00 3 Ju n. 20 04 D ec .2 00 4 Ju n. 20 05 D ec .2 00 5 Ju n. 20 0 6 D ec .2 00 6

0

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Global Risk Management Techniques - © Robert B.H. Hauswald

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Interest Rate Swap Example • Bank A: AAA-rated international bank, needs USD 10m to finance floating-rate Eurodollar loans. – considers issuing 5-year fixed-rate USD bonds at 10% – better: floating-rate notes at LIBOR to finance floatingrate Eurodollar loans.

• Firm B: BBB-rated U.S. company, needs USD 10m to finance a project with a 5 year horizon – considers issuing 5-year fixed-rate USD bonds at 11.75%: would prefer to borrow at a fixed rate – could issue 5-year FRNs at LIBOR + ½ percent. 10/11/2007

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Borrowing Opportunities • The borrowing opportunities of the two firms are shown in the following table: COMPANY B

BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

Fixed rate Floating rate

QSD = 10/11/2007

1.25%

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Interest Rate Swap Mechanics Swap Bank 10 3/8% LIBOR – 1/8%

Bank A COMPANY B Fixed rate Floating rate

10/11/2007

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

BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

QSD =

1.25%

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Interest Rate Swap Mechanics ½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. 10 3/8%

Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of

Swap Bank

-10 3/8 + 10 + (LIBOR – 1/8) =

LIBOR – 1/8%

Bank

10%

LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.

A Fixed rate Floating rate

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COMPANY B

BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

QSD =

1.25%

Global Risk Management Techniques - © Robert B.H. Hauswald

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Interest Rate Swap Mechanics 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. COMPANY B Fixed rate Floating rate

10/11/2007

Swap Bank

10 ½% LIBOR – ¼%

Company

B BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

QSD =

1.25%

Global Risk Management Techniques - © Robert B.H. Hauswald

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Interest Rate Swap Mechanics 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 10 ½% years.

Swap Bank

They can borrow externally at LIBOR + ½ % LIBOR – ¼% and have a net borrowing position of

Company

10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap. Fixed rate Floating rate

10/11/2007

B

COMPANY B

BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

QSD =

1.25%

Global Risk Management Techniques - © Robert B.H. Hauswald

LIBOR + ½%

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Interest Rate Swap Mechanics The swap bank makes money too. 10 3/8 %

Bank

LIBOR – ¼%

LIBOR – 1/8% 10%

Bank

A A saves ½ % Fixed rate Floating rate

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¼ % of $10 million = $25,000 per year for 5 years. 10 ½%

Swap

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 COMPANY B

Compan y

¼

BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

QSD =

1.25%

Global Risk Management Techniques - © Robert B.H. Hauswald

LIBOR + ½%

B saves ½ % B

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Interest Rate Swap Mechanics The swap bank makes ¼ %

Swap

10 3/8 %

Bank

10 ½% LIBOR – ¼%

LIBOR – 1/8%

Bank

10%

A A saves ½ % Fixed rate Floating rate

10/11/2007

Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD

Compan y

COMPANY B

BANK A

DIFFERENTIAL

11.75%

10%

1.75%

LIBOR + .5%

LIBOR

.5%

QSD =

1.25%

Global Risk Management Techniques - © Robert B.H. Hauswald

LIBOR + ½%

BBsaves ½ %

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The QSD • 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 creditworthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk 10/11/2007

Global Risk Management Techniques - © Robert B.H. Hauswald

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FX Derivatives Notionals: USD bn Forwards and forex swaps

Currency swaps

Options

20000 18000 16000 14000 12000 10000 8000 6000 4000 2000

Ju n.

19 De 98 c. 19 98 Ju n. 19 99 D ec .1 99 9 Ju n. 20 00 D ec .2 00 0 Ju n. 20 01 D ec .20 01 Ju n. 20 02 D ec .2 00 2 Ju n. 20 03 D ec .20 03 Ju n. 20 04 D ec .2 00 4 Ju n. 20 05 D ec .20 05 Ju n. 20 06

0

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Global Risk Management Techniques - © Robert B.H. Hauswald

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FX Gross Market Value : USD bn Forwards and forex swaps

Currency swaps

Options

700 600 500 400 300 200 100

Ju n.

19 98 D ec .1 99 8 Ju n. 19 99 D ec .1 99 9 Ju n. 20 00 D ec .2 00 0 Ju n. 20 01 D ec .2 00 1 Ju n. 20 02 D ec .2 00 2 Ju n. 20 03 D ec .2 00 3 Ju n. 20 04 D ec .2 00 4 Ju n. 20 05 D ec .2 00 5 Ju n. 20 06 D ec .2 00 6

0

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FX Risk Management Problem • Suppose a U.S. MNC wants to finance a GBP 10m 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 lot since they are not as well known abroad. 10/11/2007

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From Currency Swaps to Financial Engineering • If they can find a British MNC with a mirrorimage 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 USD 16m • Financial engineering: create synthetic instruments – borrow where one holds an advantage – use swap to generate desired cash flow profile 10/11/2007

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International Borrowing Costs • 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.

10/11/2007

$

£

Company A

8.0%

11.6%

Company B

10.0%

12.0%

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Currency Swap Mechanics Swap Bank

$9.4%

$8% £12 %

£11% $8%

Company A

10/11/2007

$

£

Company A

8.0%

11.6%

Company B

10.0%

12.0%

Company £12 % B

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Currency Swap Mechanics Swap Bank

$9.4%

$8% £11% Company A A’s net position is to borrow at £11%

$8%

Company £12 % B

$

£

Company A

8.0%

11.6%

Company B

10.0%

12.0%

A saves £.6%

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£12 %

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Currency Swap Mechanics Swap Bank

$9.4%

$8% £12 %

£11% $8%

Company A

Company £12 % B

B’s net position is to borrow at $9.4%

10/11/2007

$

£

Company A

8.0%

11.6%

Company B

10.0%

12.0%

B saves $.6%

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Putting It All Together The swap bank makes money too:

Swap Bank

$8%

1.4% of $16 million financed with 1% of £10 million per year for 5 years.

$9.4%

£12 £11% % Company £12 At S0($/£) = $1.60/£, $8% Company that is a gain of $64,000 % A B or 0.4% on $16m per The swap bank year for 5 years. faces exchange $ £ rate risk, but 8.0% 11.6% Company A maybe they can Company B 10.0% 12.0% lay it off in 10/11/2007 Global Risk Management Techniques - © Robert B.H. Hauswald 33 another swap.

Comparative Advantage as the Basis for Swaps • Which is the more credit-worthy firm? – A pays 200 bpts less to borrow in USD than B – A pays 40 bpts less to borrow in GBP than B $

£

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 10/11/2007

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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 – floating for floating

• For a swap to be possible, a QSD must 10/11/2007 Global Risk Management Techniques - © Robert B.H. Hauswald exist. Beyond that, creativity is the only limit.

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FX + Interest Rate Swap = ?

Similarly ... 10/11/2007

Fixed-Fixed Currency Swap

Currency X Currency Y

Currency of Denomination

For example, with an interest rate swap in currency X (AB) and a fixed-fixed currency swap (AC), we can construct a cross currency interest rate swap (BC).

A

C

B

Interest Rate Swap

Cross Currency Interest Rate Swap

Floating-Floating Currency Swap

Two currencies, X and Y, have both fixed-rate and floating-rate segments.

Interest Rate Base Fixed Rate Floating Rate Asset or Liability Asset or Liability

Interest Rate Swap

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Summary: Putting It All Together • Swaps: exchanging two liabilities – ex-ante: optimize funding and borrowing costs – ex-post: manage adverse FX or interest rate shocks

• Create synthetic instruments and gain twice: – issue in preferred market segment – swap into needed currency or coupon structure

• FI financial engineering: repackage cash flows – use market imperfections for return enhancements – pay only 1.5 times for two or more transactions – statistical models: limit exposures, track VAR 10/11/2007

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Appendix: Swap Transactions • Pricing swaps: fixed income mathematics • Foreign currency fixed-for-fixed swap – Walt Disney’s synthetic JPY bond

• Fixed-for-floating (plain vanilla) interest rate swap: Radobank and Goodrich – synthetic floating rate note and fixed rate bond

• Floating rate risk: buying insurance – caps and floors 10/11/2007

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Pricing Swaps • A swap is a derivative instrument so it can be priced in terms of the underlying assets: – Plain vanilla fixed-for-floating: valued just like a bond. – XFX swap: valued just like a nest of currency futures.

• Swap prices reflect – forward prices: swaps are series of forward contracts – transaction costs: spreads carry over from the appropriate market segments - tied to benchmark – credit risk: similar to FIF; essentially a counterparty (default) risk as measured by spread over benchmark – arbitrage: imposes bounds/restrictions on prices 10/11/2007

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FX Swap and Synthetic Funding • Goldman Sachs for Disney: HBS Case 9-287-058, 1987 – A&L: Disney needed JPY liability for FX risk management – borrowing opportunity in XEU (ECU) – use proceeds to refinance USD debt: interest rate management

• Swap: payment streams French Utility fixed

ECU

ECU

floating

JPY

JPY Disney

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Financial Engineering: Synthetic JPY Bond • Fixed-for-fixed currency swap: pricing by IRR – IRR argument follows from preceding picture – FX markets: intervene in fixing the principal amount

• Reasons for advantageous swaps: – GDF and Disney had saturated investor demand in their respective Eurobond segments – issue “on the other party’s home turf” and swap

• Disney creates an artificial JPY Eurobond – XEU (ECU) bond + XEU-for-JPY swap = JPY bond cash flows – gains twice: lower cost on XEU, swap gains 10/11/2007

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Interest Rate Swaps • Comparative advantage:

Goodrich Radobank Difference

Floating Fixed Rating LIBOR+50 12.50 BBB LIBOR+25 10.70 AAA

– Goodrich: – Radobank: – total savings from swap:

• Synthetic debt: compare to benchmarks – – – –

Radobank: issue fixed, swap into floating Goodrich: issue floating, swap into fixed rate debt each party keeps track of three cash flows Radobank - B.F. Goodrich, HBS 9-284-080, 1984

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X-FX Interest Rate Swaps • Comparative advantage:

Beirut P&L Deutsche Bank Difference

Floating USD Fixed DEM Rating LIBOR+150 10.50 BBB LIBOR 7.00 AA

– Beirut Power and Light: – Deutsche Bank:

• Synthetic debt: compare to benchmarks – BPL: – Deutsche Bank:

• Cash flows: two outflows, one inflow – BPL: – Deutsche Bank: 10/11/2007

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Floating Rate Risk Management • Interest rate risk with an attitude: opinions – betting on falling rates: floating rate debt – buy insurance: cap the rates

• Interest rate cap: up-front premium – an option-like instrument that pays the holder the difference between some index and actual rate – floater + cap: rates stay below a certain ceiling

• Synthetic bonds: instruments plus swaps – analyze interest rate sensitivity and pick vehicle – combine swap with option: swaption 10/11/2007

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