Managing Interest Rate Risk with
Cross Currency Swaps
Saniye Atak
Chintan Shah
Eddie Warner
NYU-SCPS. Interest Rate Swaps. X51.9204
26 July 2010
Some Tools to Manage Interest Rate
Risk
• Refinancing – go back to lender and
restructure/refinance the agreement. Not always
possible and usually expensive.
• Forward Rate Agreement – lock in future interest rate
payment. OTC market.
• Interest Rate Futures – lock in future interest rate
payments by taking a position in an interest rate
futures position.
• Interest Rate Swaps – enter into an agreement with a
bank or swap-dealer to exchange cash flows in such a
way that interest rate payments on a floating loan
would become fixed.
Cross Currency Swaps
• An agreement between two counterparties to
exchange future cash flows.
– Cross Currency Swap involves the exchange of
cash flows from one currency for those in another
with an agreement to reverse that transaction at a
future date.
– Interest Rate swaps changes the basis on which
income streams or liabilities are received or paid
on a specified principal amount.
Cross Currency Swaps
• Two cash-flow schedules in different currencies.
• Two notional amounts in different currencies.
• Motivation to enter in a cross currency swap is
the desire to pay interest in a currency with lower
rates such as JPY or CHF and receive interest in a
currency with higher rates.
• Gives companies extra flexibility to exploit their
comparative advantage in their respective
borrowing markets.
• Allows companies to explain advantages across a
matrix of currencies and maturities.
Cross Currency Swaps
• Advantages
– Beneficial interest rate payments, i.e. receiving higher
coupons or paying lower coupons than market
– Liquid and transparent product
– Zero/Low cost product
– (Partial) protection of the notional possible
• Disadvantages
– Long term FX forward risk
– Long term view on the FX rate impossible
Structure of a Cross Currency Swap
• Exchange notional amounts at inception
– Use current spot rate (CHF = Swiss Francs)
– $10m USD at 1.1138 CHF, Sfr 11.138m
• Pay/Receive intermediate cash flows
– Use bid/ask swap rates
• Re-exchange notional amounts at expiration
– Using agreed upon spot rate, 1.1138 CHF
• CHF stands for Confoederatio Helvetica Franc
Initial Exchange of Notional
Pay/Receive Intermediate Cash Flows
Re-exchange notional at expiration
Cross Currency Swap Case Study
• Carlton Corporation
– Recently took out a 3Y floating-rate loan for $10M
– Was worried interest rates would rise
– Used an Interest Rate Swap to convert to fixed
• Carlton recently signed a contract with a Swiss
buyer that will be paying Francs to Carlton
– Incoming Swiss Francs cash flows
– Good motivation for Cross Currency Swap
Interest Rate and Currency Swap Quotes
Years
1
2
3
4
5
6
7
8
9
10
12
15
20
25
30
LIBOR
Euro - €
Bid
Ask
2.99
3.02
3.08
3.12
3.24
3.28
3.44
3.48
3.63
3.67
3.83
3.87
4.01
4.05
4.18
4.22
4.32
4.36
4.42
4.46
4.58
4.62
4.75
4.82
5.00
5.04
5.13
5.17
5.19
5.23
3.0313
3.0938
Swiss Franc - Sfr
Bid
Ask
1.43
1.47
1.68
1.76
1.93
2.01
2.15
2.23
2.35
2.43
2.54
2.62
2.73
2.81
2.91
2.99
3.08
3.16
3.22
3.30
3.45
3.55
3.71
3.81
3.96
4.06
4.07
1.17
4.16
4.26
1.3125
1.4375
US Dollar $
Bid
Ask
5.24
5.27
5.43
5.46
5.56
5.59
5.65
5.68
5.73
5.76
5.80
5.83
5.86
5.89
5.92
5.95
5.96
5.99
6.01
6.04
6.10
6.13
6.20
6.23
6.29
6.32
6.29
6.32
6.28
6.31
4.9373
5.0625
Japanese
Bid
0.23
0.36
0.56
0.82
1.09
1.33
1.55
1.75
1.90
2.04
2.28
2.51
2.71
2.77
2.82
Yen - ¥
Ask
0.26
0.39
0.59
0.85
1.12
1.36
1.58
1.78
1.93
2.07
2.32
2.56
2.76
2.82
2.88
0.1250
0.2188
Setting up the Cross Currency Swap
• Carlton enters into a three-year receive US
Dollars and pay Swiss francs.
– Carlton pays 3Y CHF Ask rate (2.01%)
– Carlton receives 3Y USD Bid rate (5.56%)
• Target currency is CHF. $10M = 11.138M Sfr
– Interest Payment: 2.01% × 11.138M Sfr = 223,873.80 Sfr
• Receiving currency is USD.
– Interest Received: 5.56% × 10M = $556,000
Pay CHF & Receive USD
• Accounting practices will require mark-to-market
• If CHF appreciates, Carlton would record a loss.
• If CHF interest rates were rising, Carlton committed
to a fixed 2.01% and would record a gain.
• P&L will persist over course of swaps life.
How to price a currency swap
swap with SWPM
• SWPM is the main interest rate derivatives pricing function in the
Bloomberg professional system, allowing users to price a wide range of
vanilla and exotic interest rate swaps, interest rate options, swaptions and
interest rate / hybrid structured notes.
• We will use SWPM to price a cross currency interest rate swap transaction
and calculate a mark to market price with current markets or historicized
curves.
Example
Receive 4.5% on 10MM USD and pay floating
Euribor 3M
Notional
Effective Date
Maturity
User receives
Pay frequency
Day Count
Business days adj.
User pays Euribor
Pay frequency
Day Count
10MM USD
6/29/2010
6/29/2015
4.50% p.a
SemiAnnual
30/360
unadjusted
3M flat
Quaterly
act/360
To have a quick price of a new Interest Rate Swap transaction user has to
- open SWPM;
- enter the IRS details in the Main Screen relevant input fields;
- select Calculate Premium from Calculate menu field;
- refresh for price
In Curves Screen user can:
- visualize and export in Excel the par or zero coupon curve used for swap evaluation;
- manually override curve values;
- apply shifts to the whole curve or to defined buckets;
- choose interpolation method used;
Use the Cashflow Screen to visualize and export to an Excel spreadsheet deal cash
flows, with the ability to choose between Net, Pay, Receive and Historical cash flows.
The Risk Screen shows for each leg some key risk measures :
- DV01: the dollar value of a 1-basis-point negative shift in the curve.
- Risk: the risk for each leg and the deal is calculated according to the following
equations:
Risk = [DV01 / Notional] x 10,000