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This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging longterm interest rate risk and foreign exchange risk.
• Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Interest Rate Swaps
• Currency Swaps
1


In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.
 There are two basic types of swaps:


Single Currency Interest rate swap

“Plain vanilla” fixed-for-floating swaps in one currency.
Cross Currency Interest Rate Swap (Currency swap)
 Fixed for fixed rate debt service in two (or more) currencies.
 2006 Notional Principal for:


Interest rate swaps: US$ 229.2 trillion !!
Currency swaps: US$ 10.8 trillion

The most popular currencies are: US$, Yen, Euro, SF, BP
2


A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.

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.

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.
3


Used by companies and banks that require either fixed or floating-rate debt.

Interest rate swaps allow the companies (or banks) and the swap bank to benefit by swapping fixed-for-floating interest payments.

Since principal is in the same currency and the same amount, only interest payments are exchanged (net).
4


Each party will issue the less advantageous form of debt.
Pay floating
Swap
Bank
Pay fixed
Company A prefers floating
Receive fixed
Receive
Floating
Company B prefers fixed
Issue fixed
Issue floating
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An Example of an Interest Rate Swap
 Bank A is a AAA-rated international bank located in the UK and wishes to raise $10M to finance floating-rate Eurodollar loans.

It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

Bank A can issue 5-year fixed-rate Eurodollar bonds at 10 %

Firm B is a BBB-rated U.S. company. It needs $10 M to finance an investment with a five-year economic life.



Firm B can issue 5-year fixed-rate Eurodollar bonds at 11.75 %
Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at
LIBOR + 0.50 percent.
Firm B would prefer to borrow at a fixed rate because it locks in a financing cost.
The borrowing opportunities of the two firms are:
COMPANY B BANK A
Fixed rate 11.75%
Floating rate LIBOR + .5%
10%
LIBOR
6


QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank.

QSD arises because of a difference in default risk premiums for fixed (usually larger) and floating rate (usually smaller) instruments for parties with different credit ratings

There is no reason to presume that the gains will be shared equally, usually the company with the higher credit rating will take more of the QSD.

In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.
7

An Example of an Interest Rate Swap
10.50%
LIBOR
Bank
A
Issue $10M debt at 10% fixed-rate
Swap
Bank
The swap bank makes this offer to
Bank A: You pay LIBOR per year on $10 million for 5 years and we will pay you 10.50% on $10 million for 5 years
COMPANY B BANK A
Fixed rate 11.75%
Floating rate LIBOR + .5%
10%
LIBOR
8

An Example of an Interest Rate Swap
0.50% of $10,000,000
= $50,000. That’s quite a cost savings per year for 5 years.
10.50%
LIBOR
10%
Bank
A
Swap
Bank
Here’s what’s in it for Bank A:
Bank A can borrow externally at 10% fixed and have a net borrowing position of
-10.50% + 10% + LIBOR =
LIBOR – 0.50% which is 0.50
% better than they can borrow floating without a swap.
COMPANY B BANK A
Fixed rate 11.75%
Floating rate LIBOR + .5%
10%
LIBOR
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An Example of an Interest Rate Swap
The swap bank makes this offer to company
B: You pay us 10.75% per year on $10 million for 5 years and we will pay you
LIBOR per year on
$10 million for 5 years.
Swap
Bank
LIBOR
10.75%
10%
LIBOR
Company
B
Issue $10M debt at
LIBOR+0.50% floating-rate
COMPANY B BANK A
Fixed rate 11.75%
Floating rate LIBOR + .5%
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An Example of an Interest Rate Swap
Here’s what’s in it for Firm B:
Firm B can borrow externally at
LIBOR + .50 % and have a net borrowing position of
Swap
Bank
0.5 % of $10,000,000 =
$50,000 that’s quite a cost savings per year for 5 years.
10.75%
LIBOR
Company
10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which is 0.50 % better than they can borrow floating
(11.75%).
COMPANY B BANK A
B
LIBOR
+ .50%
Fixed rate 11.75%
Floating rate LIBOR + .5%
10%
LIBOR
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An Example of an Interest Rate Swap
The swap bank makes money too.
Bank
A
10.50%
Swap
Bank
.25% of $10 million =
$25,000 per year for 5 years.
10.75%
LIBOR LIBOR
LIBOR+10.75%– LIBOR-10.50%=0.25%
Company
B
COMPANY B BANK A
Fixed rate 11.75%
Floating rate LIBOR + .5%
10%
LIBOR
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An Example of an Interest Rate Swap
The swap bank makes .25%
Swap
Bank
10.50%
10.75%
LIBOR LIBOR
Bank Company
A
A saves .50%
B
B saves .50%
COMPANY B BANK A
Fixed rate 11.75%
Floating rate LIBOR + .5%
10%
LIBOR
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Example: Interest Rate Swap

Company A can borrow at 8% fixed or LIBOR + 1% floating (borrows fixed)
 Company B can borrow at 9.5% fixed or LIBOR + .5% (borrows floating)

Company A prefers floating and Company B prefers fixed
 By entering into the swap agreements, both A and B are better off then they would be borrowing from the bank and the swap dealer makes .5%
Pay Receive Net
Company A
Swap Dealer w/A
Company B
Swap Dealer w/B
Swap Dealer Net
LIBOR
7.75%
8.25%
LIBOR
8%
LIBOR
LIBOR
8.5%
LIBOR+7.75% LIBOR+8.25%
-(LIBOR+.25)
-8.75%
+0.50%
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


Ex., U.S. parent company wants to finance a project undertaken by its subsidiary in Germany. Project proceeds would be used to pay interest and principal.
1.
2.
3.
Options:
Borrow US$ and convert to Euro – exposes company to exchange rate risk.
Borrow in Germany – rate available may not be as good as that in the U.S. if the subsidiary is relatively unknown.
Find a counterparty and set up a currency swap.
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
Typically, a company should have a comparative advantage in borrowing locally
Pay foreign
Swap
Bank pay foreign
Company
Receive local
Receive local
Company
Issue local
Issue local
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
Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a German plant.
 They could borrow dollars in the U.S. where they are well known and exchange for dollars for euros.

This will give them exchange rate risk: financing a euro project with dollars.

They could borrow euro in the international bond market, but pay a premium since they are not as well known abroad.

If they can find a German MNC with a mirror-image financing need they may both benefit from a swap.
 If the spot exchange rate is S
0
($/ €) = $1.30/ €, the U.S. firm needs to find a German firm wanting to finance dollar borrowing in the amount of $52,000,000.
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
Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a Germany–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.
$ €
8.0% 7.0%
9.0% 6.0%
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$8%
Borrow
$52M
Annual
Interest
$4.16M
$8%
Firm
A
€ 6%
Annual
Interest
€2.4 M
Swap
Bank
Annual
Interest
$4.16M
$8%
€ 6%
Annual
Interest
€2.4 M
Firm
B
€ 6%
Borrow
€ 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
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A’s net position is to borrow at € 6%
$8%
$52M
Firm
A
$8%
€ 6%
Swap
Bank
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
B’s net position is to borrow at $8%
$8%
€ 6%
Firm
B
€ 6%
€ 40M
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
Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs. They also make a market in “plain vanilla” and currency swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

Interest Rate Swap Example:
 Swap bank terms: USD: 2.50 – 2.65
Means that the bank is willing to pay fixed-rate 2.50% interest against receiving
LIBOR OR bank is willing to receive fixed-rate 2.65% against paying LIBOR.

Currency Swap Example:

Swap bank terms: USD 2.50 – 2.65
Euro 3.25 – 3.50
Means that bank is willing to make fixed rate USD payments at 2.5% in return for receiving fixed rate Euro at 3.5% OR the bank is willing to receive fixed-rate USD at 2.65% in return for making fixed-rate Euro payments at 3.25%
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Interest Rate Risk
 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.
Basis Risk
 Floating rates of the two counterparties being pegged to two different indices
Exchange rate Risk
 Exchange rates might move against the swap bank after it has only gotten half of a swap set up.
Credit Risk
 This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.
Mismatch Risk
 It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk
 The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.
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