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Interest Rate & Currency

Swaps (ch14)

Learning Objectives
Swap market and swap bank
Interest rate swaps
Currency swaps
Pricing interest rate and currency swaps
Risk of interest rate and currency swaps
Swap market efficiency


In a swap, two counterparties agree to a contractual arrangement
wherein they agree to exchange cash flows at periodic intervals.
Two types of interest rate swaps:
Single currency interest rate swap
One counterparty exchanges the interest payments of one debt
obligation for the interest payments of another debt obligation.
The periodic cash flows are in the same currency.
Typically shortened as “interest rate swap”
Basic (“plain vanilla”) interest rate swap: fixed-for-floating swap
Cross-currency interest rate swap
One counterparty exchanges the debt service obligation
denominated in one currency for the debt service obligation of
the other counterparty denominated in another currency.
Often shortened as “currency swap”
Basic currency swap: fixed-for-fixed swap

dollar Japanese yen Euro Swiss franc British pound sterling 4 .S. a reference amount for determing interest payments The most common currencies used to denominate swaps: U.Swap Market Size of the swap market: measured by notional principal.

As a broker. The swap bank can serve as either a broker or a market maker (dealer). As a market maker. or matches it with a counterparty. the swap bank takes certain risks. 5 . By acting as either side of the swap. and then later lays off its risk. the swap bank stands ready to be either side of the swap. the swap bank charges commissions to match counterparties but does not take any side of the swap.The Swap Bank A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.

“flat” means “no credit premium” 6 . Currency swap rates against U. dollar LIBOR flat. Swap banks also make a market in generic “plain vanilla” swaps and provide quotations applicable to counterparties with Aa or Aaa credit ratings.Swap Market Quotations Swap banks can tailor the terms of interest rate or currency swaps to customers’ needs. It is a convention for swap banks to quote: Interest rate swap rates against a local standard reference in the same currency.S.

18 1.75% against 3.15at 2.50 against paying LIBOR 4.56 4.18 4.11 5.82 3.21 5.17 1.85 The swap bank will 2 year 2.45 4.16 $ payments 2.01 4.58 5.10 5.13 2.S.48 2.66 9 year 3.26 The5.77 10 year 3.62 2.56 2.34 2.46 receiving 4.54 3.12 5.Interest Rate Swap Quotations Euro-€ Bid Ask £ Sterling Bid Ask Swiss franc U.89euro5.92 0.31 3.70 4.74 3.79 (2) receive fixed-rate $ payments at 4.94 (1) pay fixed-rate euro payments at 3.37 4.55 4.85%1.09 5.81 4.11 5.79% against paying fixed-rate 5.23 3.13 payment SF payment 5.64 4.25 2.98 3.58 euro4.25 4.57 4 year 3.50 fixed-rate 7 year 3.62 4.33 4.38 pay fixed-rate at2.10 5. $ Bid Ask Bid Ask 1 year 2.66 SF payment at 2.08 5.82% against receiving euro LIBOR payment 2.52 3.14 5.06 3.41 (1) 5.23 1.73 1.86 fixed-rate payments5.63 3.37 5.37 2.10 4.14 2.22 0.93 2.56% 7 .65 5.09 5.11 (2)3 year receive2.72 5.28 5 year 3.15 2.39 6 year 3.17 at 3.55 8 year 3.90 3.64% 2.16 swap bank will 1.13 1.75 4.

Firm B is a BBB-rated U.000 to finance a 5-year.000 to finance a 5-year project. company. Issue 5-year FRNs at LIBOR + 0.Interest Rate Swap: an Example Bank A is a AAA-rated international bank located in U. 000: Issue 5-year fixed-rate Eurodollar bonds at 10% Issue 5-year floating-rate notes (FRNs) indexed to LIBOR Bank A prefers the floating-rate borrowing due to the floatingrate loan issued to its customers.K.5%. Bank A has two options to raise $10. bond market. Firm B has two financing options: Issue 5-year fixed-rate bonds at 11. It needs $10.S.000. It plans to raise $10.000. 000.S.. 8 . floating-rate Eurodollar loan issued to its customer.25% in the U. Firm B would prefer to borrow at a fixed rate.

Interest Rate Swap Via the Swap Bank The borrowing costs of the two firms: Fixed Rate B (Prefers fixed rate) A (Prefers floating rate) 11.5% LIBOR  The swap bank makes a market for 5-year plain-vanilla swaps at 10.375-10. 9 .50 against dollar LIBOR.25% 10% Floating Rate LIBOR+0.

Receive fixed-rate payment (10.Swap by Bank A Bank A will do the followings: Issue 5-year fixed-rate bonds to raise $10 million at 10% (which is not what A prefers) Swap: Make LIBOR payment (LIBOR on $10 million) to the swap bank. 10 .375% on $10 million) from the swap bank. Net Result: Bank A converts its fixed-rate debt into floating-rate debt at an all-in cost (AIC) lower than the floating rate it could arrange on its own.

cost savings per year: 0.375%=LIBOR – Bank 0.The All-in Cost (AIC) for Bank A Swap The all-in cost for Bank A: 10% + LIBOR -10.375% on its own.375%.375% (37. which is 0.375 % lower than what A can borrow floating-rate loan at 10.5bps) LIBOR 10% Bank A 11 .

Swap by Firm B Firm B will do the followings: Issue 5-year floating-rate notes to raise $10 million (which is not what B prefers) Swap: Make fixed-rate payment (10. 12 . Net result: Company B converts its floating-rate debt into fixed-rate debt at an all-in cost (AIC) lower than the fixed rate it could arrange on its own.5% on $10 million) to the swap bank. Receive LIBOR payment (LIBOR on $10 million) from the swap bank.

LIBOR = 11%.The All-in Cost (AIC) for Company B Swap The All-in Cost for Company B: Bank 10.25% lower than what B can borrow at fixed-rate on its own.5% 13 .5% LIBOR Company B LIBOR + 0. cost savings per year: 0.5%) .5% + (LIBOR + 0.25% (25bps) 10. which is 0.

5% .Profit Earned by the Swap Bank The swap bank makes money too! 10.125% (12.5bps) per year for 5 years Swap 10 3/8% LIBOR Bank 10 ½% LIBOR Bank Company A B 14 .10.375% =0.

Comments on Interest Rate Swap Benefits of using interest rate swaps To better match the maturities of assets and liabilities To obtain a cost saving on borrowing The principals of the debts are not exchanged. only the net difference of interest payments is exchanged. 15 . In practice.

Quality Spread Differential (QSD) QSD=Default Risk Premium (DRP) differential on Debt #1 (e.g. There is no reason to presume that the gains will be shared equally. the floating-rate debt) QSD represents the potential gains from the swap shared by two counterparties and the swap bank. A positive QSD is the necessary condition for a swap to be possible. 16 .g. the fixed-rate debt) minus DRP differential on Debt #2 (e. In general. less credit-worthy firm would get less of the QSD to compensate the swap bank for the default risk.

5bps) Swap Bank 10.5 bps) B saves 0.75%=75bps 17 .375% (37.5%-LIBOR) QSD=0.25%-10%) -(LIBOR+0.25% (25 bps) QSD=(11.375% LIBOR 10.How QSD is Shared The swap bank earns 0.5% LIBOR Bank Company A B A saves 0.125% (12.

Exchange rate risk (for currency swap) Sovereign risk (for currency swap): The government imposes exchange rate restrictions on a currency involved in a swap. 18 . the swap bank may pay more than it receive if the indexes are not perfectly correlated. Mismatch risk It’s hard to find an exact match for a swap the swap bank has agreed to take. Interest rate risk: Interest rates may change unfavorably before the swap bank can lay off the swap it undertakes with one counterparty. the maturity dates or the debt service dates. Basis risk When the floating rates are not pegged to the same index. This is the major risk faced by a swap bank.Risks for the Swap Bank Credit risk: a counterparty will default on its payment. The mismatch may be with respect to the size of the principals.

000). €40.S.000. they have to pay higher interest rate if they borrow foreign currency in the international bond market: The U. MNC and a German MNC have a mirror-image financing need: Both plan to raise funds to finance a 5-year project by its foreign subsidiary: The German MNC needs to raise $52.S.e. MNC needs to raise the equivalent amount in € at the current spot rate $1. The U. Both MNCs are of the same creditworthiness. MNC pays 8% in $ borrowing but 7% in € borrowing.Currency Swap: an Example A U. Because both MNCs are less well-known outside their domestic capital market.3/€ (i.000. 19 . The German MNC pays 6% for € borrowing but 9% for $ borrowing.S.000.

U. 20 . it has to borrow at a disadvantageous rate. MNC’s German subsidiary may not earn enough € to service the dollar loan.S. E. Solution: use currency swap to restrcture financing and mitigate risks. if $ appreciated substantially against the € over 5-year period. If the parent firm raises money (denominated in foregin currency) in intertional bond market.g.Challenges for the MNC If the parent firm raises money in domestic capital market to finance its foreign projet: A long-term transaction exposure to foreign currency risk will be created.

Every year.000 to pay off its € borrowing.Cash Flows Result from the Currency Swap Assume bid-ask spread is zero 5-year $ swaps at 8.00 percent against $ LIBOR A 5-year currency swap can be arranged by the swap bank as follows: First.000 at 6% and swaps the € amount for $52. both MNCs raise funds in their domestic capital markets and then swap the principals with the swap bank: The German MNC borrows €40.000.160. 21 . MNC borrows $ at 8% and swaps the $ amount for €40.S.000.400.000. the principals are swapped back so that both MNCs can pay off the debts raised in their domestic capital markets.000 and get back €40.00-6.000 and get back $52. The German MNC will return $52.000.00 percent against $ LIBOR 5-year € swaps at 6. On debt retirement date (maturity date).000 and receives €2.000 to pay off its $ borrowing.000 The US MNC receives $ The US MNC will return€40. each MNC pays and receives interests based on the term of the swap contract it entered into: The German MNC pays $4.00-8.000 The FC interest payments will be covered by the money earned by their foreign subsidiaries.000 and pays €2. The U.

both MNCs restructure their debts to mitigate risk and obtain cost-saving: The U. 22 . with a cost saving of 1%. MNC in net borrows euro at an all-in-cost (AIC) of 6% (vs. 9% it would have to pay in the Eurobond market).Net Result Through currency swap. with a cost saving of 1%.S. The German MNC in net borrows $ at an all-in-cost (AIC) of 8% (vs. 7% it would have to pay in the Eurobond market).

g. To obtain a cost saving on borrowing. 23 . currency swap helps exchange one debt for another (e. a $-denominated debt exchanged for a €-denominated debt) Benefits of using currency swaps To manage long-term exposure to FX risk. In fact.Comments on Currency Swap Both the principal of the debt and the interest payments are exchanged.

15 percent against $ LIBOR 5-year € swaps at 6.Currency Swap with Bid-Ask Spread Since the swap bank takes risks by making a market for swaps.10 percent against $ LIBOR 24 . the bid-ask spread will not be zero. Now assume the swap bank is quoting 5-year $ swaps at 8.00-8.00-6.

Currency Swap Via Swap Bank Swap Bank $8% €6. MNC $8.15% €6% German MNC €6% 25 .1% $8% U.S.

Net Result The U. Profit earned by the swap bank: 0. split among the swap bank and two MNCs. MNC in net borrows euro at an all-in-cost (AIC) of 6.25% (25bps) QSD=1%-(-1%)=2% (200bps).9% (90bps). The German MNC in net borrows $ at an all-in-cost (AIC) of 8.15% (vs. 7% it would have to pay in the Eurobond market) Its cost saving is 0. 26 .S. Remember that a positive QSD is the necessary condition for a swap to be possible.1% (vs.85% (85 bps). 9% it would have to pay in the Eurobond market) Its cost saving is 0.

S. suppose that the U. A curreny swap is still possible since QSD=200bps The German MNC will gets 85bps. The U. There are still 5bps left for the swap bank. 27 .1%).S. the swap bank can tailor swaps to serve all parties' needs. MNC is only willing to enter into the currency swap with a cost saving of 110bps (1.In Depth Remember that a positive QSD is the necessary condition for a swap to be possible. As long as QSD is positive. E.g. MNC wants to get 110bps.

Currency Swap Via Swap Bank Swap Bank $8.S. a compromise it takes to layoff its risk. MNC $8. 28 . the swap bank pays more than it receives on $-side of the swap.20% €6.15% €6% German MNC €6% In this case.1% $8% U.

After the inception of a swap contract. it may become desirable for one and/or the other counterparty to unwind the swap. if interest rate or exchange rate changes. 29 . The value of a swap contract is zero at initiation.Pricing a Swap Contract The value of a swap to a counterparty is determined by the difference between the PV of CFs it will receive and the PV of CFs it will pay.

418.4.75%). interest rates and exchange rate have changed: Interest rates decreased to $6. 4. 170 .4M.4.000 to borrow at 6.517 to the German MNC: € 41. 170 /$1. The German MNC should be willing to accept this amount to sell the swap.75%) The market value of € debt is €41.75%.517. 170: PVA($4.380: PVA(€2. 4.75%) +PV($52M.6. 5%)+PV(€ 40 M.418.€ 41. One or both counterparties might have incentives to unwind the swap in order to refinance at lower rate.310/€ = €33. 5%) The U.214.Pricing the Basic Currency Swap Assume 1 year after the currency swap was arranged. 214. MNC should be willing to pay to unwind the swap (so that it could refinance $52.380* $1. 30 . 6. $54. and €5%.418.16M.310/€. The spot rate is S1($/€) = $1. The market value of $ debt is $54.908 The swap has a value of €33.380-$54. 214.S.000.310/€=-$43.

0375M. The market value of the 10.000. 958 to unwind the original swap contract.5% while receiving LIBOR.4.485.4. 31 .000.4.Pricing the Basic Interest Rate Swap Now assume that 1 year after the inception of the swap.461. The market value of the floating rate debt is $10.375% fixed rate debt is $10.4. PVA($1. B would be willing to pay up to $485.9%) Firm B has incentive to unwind the original swap since it pays 10.958.461 to bank A.5% fixed rate debt is $10.9%)+PV($10M. The value of the swap contract is $445.00-9. the swap bank is quoting 4-year dollar interest rate swaps at 9.445. PVA($1.125 percent against dollar LIBOR flat.9%) The market value of the 10.05M.9%)+PV($10M.

Development & Growth of the Swap Market The development and growth can be explained by “market completeness hypothesis”: Not all types of debt instruments are available to all types of borrowers. 32 . Swaps allow tailored financing to borrowers and thus offer market completeness.

Learning Outcomes Conduct interest rate/currency swap cash flow analysis Discuss the motivation of a counterparty to enter into interest rate/currency swaps Calculate the all-in cost (AIC) for a swap counterparty Calculate the profit earned by the swap bank Price interest rate and currency swaps Discuss the risks a swap bank encounters in interest rate and currency swaps 33 .