8/26/14

INTERNATIONAL FINANCIAL MANAGEMENT Seventh Edition EUN / RESNICK

14-0

Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Interest Rate & Currency Swaps Chapter Objective:

14

Chapter Fourteen

INTERNATIONAL FINANCIAL MANAGEMENT

This chapter discusses currency and interest rate swaps, which are instruments for hedging longFourth Edition term interest rate risk and/or foreign exchange risk. EUN / RESNICK

14-1

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

1

8/26/14

Chapter Outline Types of Swaps l  Size of the Swap Market l  The Swap Bank l  Interest Rate Swaps l  Currency Swaps l 

14-2

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline (continued) Swap market quotations l  Variations of basic currency or interest rate swaps l  Risks of interest rate or currency swaps l  Swap market efficiency l  Concluding thoughts about swaps l 

14-3

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

2

8/26/14

Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. l  There are two types of interest rate swaps: l 

n 

Single-currency interest rate swap u “Plain

vanilla” fixed-for-floating swaps are often just called interest rate swaps.

n 

Cross-Currency interest rate swap u This

is often called a currency swap; fixed- for fixed-rate debt service in two (or more) currencies. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-4

Size of the Swap Market l 

By H1-2013, notional for non-option IR / currency OTC derivatives stood at $592 trillion (BIS) Growth: $57 trillion “only” in 2001 (ISDA) n  Currency swaps = small fraction of the total (BIS) n 

$26 trn currency swaps (up), $437 trn IR swaps (way up) ISDA ≠ BIS estimates (IRS Clearing  double-counting)

u  u 

u FX

l 

swaps vs. currency swaps

The most popular currencies are: n 

U.S. dollar, Euro, Japanese yen, UK pound u 5th

14-5

“one”: Swedish Krone (IR) and Swiss franc (currency)

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

3

8/26/14

The Swap Bank l  A

swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. l  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. n  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. n 

14-6

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

An Example of an Interest Rate Swap Consider this example of a “plain vanilla” interest rate swap. l  Bank A is a AAA-rated international bank located in the U.K., that wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. l 

n 

n 

14-7

Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent… … Yet it would make more sense for the bank to issue floating-rate notes at LIBOR even to finance floating-rate Eurodollar loans. (why?) Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

4

8/26/14

An Example of an Interest Rate Swap l 

Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a fiveyear economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. n  Alternatively, firm B can raise the money by issuing 5year floating-rate notes at LIBOR + ½ percent. n  Firm B would prefer to borrow at a fixed rate. n 

14-8

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

An Example of an Interest Rate Swap The borrowing opportunities of the two firms are: COMPANY

Fixed rate Floating rate

14-9

B

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

5

8/26/14

An Example of an Interest Rate Swap The swap bank makes this offer to Bank A: You pay us 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 10 3/8%

Bank

LIBOR – 1/8%

Bank A COMPANY Fixed rate Floating rate

B

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-10

An Example of an Interest Rate Swap ½% of $10,000,000 = $50,000. That’s quite a cost savings per year 10 3/8% 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

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 COMPANY Fixed rate Floating rate

14-11

B

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

6

8/26/14

An Example of an Interest Rate Swap 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 COMPANY

Fixed rate Floating rate

B

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-12

An Example of an Interest Rate Swap Here’s what’s in it for B: They can borrow externally at LIBOR + ½ % and have a net

½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. 10 ½%

Swap Bank

LIBOR – ¼%

Company

borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. COMPANY Fixed rate Floating rate

14-13

B

B

LIBOR + ½%

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

7

8/26/14

An Example of an Interest Rate Swap The swap bank makes money too. 10 3/8%

Bank

10 ½%

LIBOR – 1/8%

Bank

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

Swap

LIBOR – ¼%

Company

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

A

B

10 ½ - 10 3/8 = 1/8 COMPANY Fixed rate Floating rate

B

¼

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-14

An Example of an Interest Rate Swap The swap bank makes ¼% Swap 10 3/8%

Bank 10 ½%

LIBOR – 1/8% 10%

Bank

Company

A A saves ½%

B COMPANY

Fixed rate Floating rate

14-15

LIBOR – ¼%

B

LIBOR + ½%

B saves ½%

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

8

8/26/14

An Example of a Currency Swap Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. l  They could borrow dollars in the U.S. where they are well known, and exchange for dollars for pounds. l 

Problem: This will give them exchange rate risk as they will be financing a sterling project with dollars.

n 

l 

They could borrow pounds in the international bond market, but pay a premium since they are not as well-known abroad. 14-16

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

An Example of a Currency Swap If they can find a British MNC with a mirrorimage financing need they may both benefit from a swap. l  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. l 

14-17

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

9

8/26/14

An Example of a Currency Swap Consider two firms A and B: - firm A is a U.S.–based multinational - 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%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-18

An Example of a Currency Swap Swap Bank $8%

$9.4%

£11% $8%

14-19

£12%

Firm

Firm

A

B $

£

Company A

8.0%

11.6%

Company B

10.0% 12.0%

£12%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

10

8/26/14

An Example of a Currency Swap A’s net position is to borrow at £11%

Swap Bank $9.4%

$8% £11% $8%

£12%

Firm

Firm

A

£12%

B

A saves £.6% $

£

Company A

8.0%

11.6%

Company B

10.0% 12.0%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-20

An Example of a Currency Swap B’s net position is to borrow at $9.4%

Swap Bank $9.4%

$8% £11% $8%

14-21

£12%

Firm

Firm

A

B $

£

Company A

8.0%

11.6%

Company B

10.0% 12.0%

£12%

B saves $.6%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

11

8/26/14

An Example of a Currency Swap The swap bank makes money too:

Swap Bank

$8% £11% $8%

Firm A

£12%

At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years. Company A Company B

14-22

1.4% of $16 million financed with 1% of £10 million per year $9.4% for 5 years. Firm

£12%

B The swap bank faces $ £ exchange rate risk, 8.0% 11.6% but maybe they can 10.0% 12.0% lay it off (in another swap).

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

The QSD The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank. l  There is no reason to presume that the gains will be shared equally. l  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. l 

14-23

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

12

8/26/14

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: $

£

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. 14-24

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Comparative Advantage as the Basis for Swaps B has a comparative advantage in borrowing in £. B pays 2% more to borrow in dollars than A $

£

Company A

8.0%

11.6%

Company B

10.0% 12.0%

B pays only 0.4% more to borrow in pounds than A 14-25

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

13

8/26/14

Comparative Advantage as the Basis for Swaps 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. 14-26

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Swap Market Quotations l 

l 

l 

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, for a currency swap quote, 6.60 — 6.85 means the swap bank will pay fixed-rate FX payments at 6.60% against receiving dollar LIBOR or it will receive fixed-rate FX payments at 6.85% against receiving dollar LIBOR. 14-27

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14

8/26/14

Interest Rate & Currency Swap Quotes Euro-€ Bid

£ Sterling

Ask

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 3.82–3.85 5.13 5.17 means 1.50 the

4 year

3.06

5 year

3.23

6 year

3.38

7 year

3.52

1.58bank4.11 4.13 swap will pay 3.09 fixed-rate 5.12 5.17 1.73 1.81 4.25 4.28 euro payments at 3.82% 3.26 against 5.11 receiving 5.16 1.93 2.01 4.37 4.39 dollar LIBOR or it will 3.41 receive 5.11 fixed-rate 5.16 2.10 2.18 4.46 euro payments at 4.50 3.55 3.85% 5.10 against 5.15 receiving 2.25 2.33 4.55 4.58 dollar 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

10 year

3.82

3.85

5.08

5.13

2.56

2.64

4.75

4.79

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-28

Swap Quotations 3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR

Firm B

€3.85% $LIBOR

Swap Bank

€3.82% $LIBOR

Firm A

While most swaps are quoted against “flat” dollar LIBOR, “off-market” swaps are available where one party pays LIBOR plus or minus some number. 14-29

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

15

8/26/14

Variations of Basic Currency and Interest Rate Swaps l 

Currency Swaps fixed for fixed n  fixed for floating n  floating for floating n  amortizing n 

l 

Interest Rate Swaps zero-for floating n  floating for floating n 

l 

For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

14-30

Risks of Interest Rate and Currency Swaps l 

Interest Rate Risk n 

l 

Basis Risk n 

l 

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. If the floating rates of the two counterparties are not pegged to the same index.

Exchange Rate Risk n 

14-31

In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

16

8/26/14

Risks of Interest Rate and Currency Swaps (continued) l 

Credit Risk n 

l 

Mismatch Risk n 

l 

This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap. It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.

Sovereign Risk n 

14-32

The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: l  How to: l 

Any swap’s value is the difference in the present values of the payment streams that are incoming and outgoing. n  Plain vanilla fixed-for-floating swap gets valued just like a bond. (What is, roughly, the floating leg worth?) n  Currency swap gets valued just like a nest of currency futures. n 

14-33

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

17

8/26/14

Swap Market Efficiency Swaps offer market completeness, and that has accounted for their existence and growth. l  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. l 

14-34

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Concluding Remarks The growth of the swap market has been astounding, from about 865bn US dollars in 1987 to more than 460 trillion US dollars in 2013. l  Swaps have become an important source of revenue and risk for banks l  Because of transactions costs associated with foreign/euro bond deals, swaps are here to stay. l 

14-35

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18

8/26/14

End Chapter Fourteen

14-36

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

19