Chapter 9
Interest Rate and
Currency Swaps
The Goals of Chapter 9
• Define the interest rate risk for MNEs
– It can be decomposed into the credit risk, reprising risk,
and currency risk
• For domestic interest rate risk, discuss the following
management alternatives
–
–
–
–
Refinancing
Forward rate agreement
Interest rate futures
Interest rate swaps
• Introduce various types currency swaps
• Discuess the counterparty risk for swaps
9-2
Interest Rate Risk
9-3
Interest Rate Risk
• All firms–domestic or multinational, small or large,
leveraged, or unleveraged–are sensitive to interest rate
movements
– The changes of interest rates could introduce risk into the
future cash flows of the firm
• The largest interest rate risk of the nonfinancial firm,
i.e., excluding financial institutions, is debt service
– Particularly, the multicurrency dimension of interest rate risk
for the MNE is of serious concern in this chapter
• The second most prevalent source of interest rate risk for
the MNE lies in its holdings of interest-sensitive securities
– Unlike debt, which is recorded on the right-hand (liability) side of
the firm’s balance sheet, the marketable securities portfolio of the
firm appears on the left-hand (asset) side of the balance sheet
– E.g., MNEs invest their excess funds in Treasury bonds
9-4
Interest Rate Risk
• Before talking about the interest rate risk of debt
service, different day-count convention for moneymarket instruments, e.g., short-term loans or bank
deposits, in different nations are shown as follows
※ “International” indicates short-term loans in all Eurocurrencies except
Eurosterling, which adopts actual/365 day-count basis for quotation
※ In practice, for different instruments, it is possible to have different day-count
convention in a nation, e.g., in the U.S., actual/actual for Treasury bonds, 30/360
for corporate bonds, and actual/360 for money market instruments
9-5
Interest Rate Risk
• The composition of the interest rate risk for MNE
borrowers
– Credit risk, sometimes termed roll-over risk, is the
possibility that a borrower’s credit worthiness, at the time
of renewing a credit, is reclassified by the bank (resulting
in changes to fees, interest rates, credit line commitments
or even denial of credit)
– Repricing risk is the risk pertaining to floating rate debts,
i.e., the risk of changes in interest rates charged at the time
a financial contract’s rate is reset
– Currency risk exits if MNEs borrow foreign debts
• For the domestic environment, the comparison among the
following strategies of borrowing $1 million for a threeyear period illustrates the credit risk and repricing risk
9-6
Interest Rate Risk
– Strategy 1: Borrow $1 million for 3 years at a fixed interest rate
• Since the future interest payments are fixed, there is no interest
rate risk for the borrower
– Strategy 2: Borrow $1 million for 3 years at a floating rate,
LIBOR + 2%, to be reset annually
• Since the interest rate is reset (repriced) annually, the borrower
faces the repricing risk, which causes the uncertainty of future
interest payments (the rate could be reset upward or downward)
• The 2% is the credit premium to reflect the creditworthiness of
the borrower at the beginning. Since the credit premium is a
constant, there is no credit risk for the borrower
– Strategy 3: Borrow $1 million for 1 years at a fixed rate, and
then renew the loans annually
• For the shorter time to maturity, the borrowers could borrow at a
lower interest rate
• For the annual renewal, the new interest rate may reflect both the
prevailing 1-year interest rate (reprising risk) and the
creditworthiness of the borrower at that time point (credit risk)
9-7
Management of Interest
Rate Risk
9-8
Management of Interest Rate Risk
• Both foreign exchange and interest rate risk
management must focus on managing existing or
anticipated cash flow exposures of the firm
• Before treasurers and financial managers manage
interest rate risk, they must resolve a basic
management dilemma: the balance between risk and
return
– A higher expected return must accompany higher risk
– In other words, eliminating all risks means eliminating the
future expected return brought by the investment
9-9
Management of Interest Rate Risk
• Treasury has traditionally been considered a service
center (cost center) and is therefore not expected to
take positions that incur risk in the expectation of
profit
– Treasury management practices are therefore predominantly
conservative, i.e., to reduce the risk as could as possible
– However, opportunities to reduce costs or actually earn
profits from managing interest rate risk should not be ignored
• Another issue is that whether stockholders want
management to hedge interest rate risk or prefer to
diversify the risk away by themselves
– For both the interest rate and exchange rate risks, firms stand
at a better position to estimate and hedge both risks, but
stockholders can reduce both risks through diversification
without any costs
9-10
Management of Interest Rate Risk
• Similar to managing foreign exchange exposure, the
firm cannot undertake management or hedging
strategies without forming expectations–a direction–of
interest rate movements
– Comparing to the foreign exchange rate movements, interest
rate movements have historically shown more stability
• Once management has formed expectations about
future interest rate levels, it must choose the
appropriate implementation, including the selective
use of various techniques and instruments
– Several interest rate derivatives are considered for hedging,
e.g., forward rate agreements, interest rate futures, interest
rate swaps, or interest rate options
9-11
Management of Interest Rate Risk
• As an example, Trident Corporation has taken out a
three-year, floating-rate (LIBOR+1.5%) loan in the
amount of US$10 million (annual interest payments)
※ The LIBOR will be reset each year on an agreed-upon date, which is assumed
to be two days prior to payment
※ The AIC, defined as the IRR of total CFs, estimates the average cost of debt
9-12
Management of Interest Rate Risk
• Note that even for fixed interest rate loan, it has the
interest rate risk, which only influences the opportunity
cost but does not put actual cash flows at risk
– If interest rates decline, the firm still needs to pay a higher
interest rate, which causes an opportunity loss for the firm
– This course focuses only on the cash flow risk associated
with the interest rate and exchange rate risks
• Some alternatives available to management as a means
to manage interest rate risk are as follows:
– Refinancing
• Trident restructures and refinances the entire agreement with
the bank, which is not always possible and often expensive
– Forward rate agreements (FRAs)
– Interest rate futures
– Interest rate swaps
9-13
Management of Interest Rate Risk
• A forward rate agreement (FRA) is an over-thecounter contract to buy or sell interest rate payments
on a notional principal
• The buyer of an FRA obtains the right to lock in an
interest rate for a desired period of time that begins at
a future date
• These contracts are settled in cash in either scenario
1. Interest rates rise above the agreed rate: the seller of the FRA
will pay the buyer the increased interest expense on the
notional principal
2. Interest rates fall below the agreed rate: the buyer will pay
the seller the differential interest expense on the notional
principal
※The example to illustrate the settlement of FRA is on the
next slide
9-14
Management of Interest Rate Risk
• Trident can buy a FRA to lock the LIBOR for the
second-year interest payment to be 5%
– If LIBOR rises to become 6% for the second year, Trident would receive
a cash payment of $10 million×(6%–5%) from the FRA seller
– If LIBOR declines to become 3% for the second year, Trident would pay
a cash payment of $10 million×(5%–3%) to the FRA seller
※ In both cases, the effective interest rate that Trident pays is 5% plus the
credit premium of 1.5%
• Examples of the notation for FRAs
Notation
Effective Date from
Now
Termination Date from
Now
Underlying Rate
1×4
1 month
4 months
4–1 = 3-month LIBOR
1×7
1 month
7 months
7–1 = 6-month LIBOR
3×6
3 months
6 months
6–3 = 3-month LIBOR
3×9
3 months
9 months
9–3 = 6-month LIBOR
6 × 12
6 months
12 months
12–6 = 6-month LIBOR
12 × 18
12 months
18 months
18–12 = 6-month LIBOR
9-15
Management of Interest Rate Risk
• Interest rate futures are futures contracts whose
underlying security is a debt obligation, e.g.,
Treasury-bill futures, Treasury-bond futures, or
Eurodollar futures
• Unlike foreign currency futures, interest rate futures
are relatively widely used by financial managers and
treasurers of nonfinancial companies
– Their popularity stems from the relatively high liquidity of
the interest rate futures markets, their simplicity in use, and
the rather standardized interest-rate exposures most firms
possess
• The two most widely used futures contracts are the
Eurodollar futures traded on the Chicago Mercantile
Exchange (CME) and the US Treasury Bond
Futures on the Chicago Board of Trade (CBOT)
9-16
Exhibit 9.5 Eurodollar Futures
Prices
• Eurodollar futures are futures locking the 3-month
Eurodollar deposit rate at the maturity of the futures
※ The quoted price of an Eurodollar futures contract is 100–100×3-month LIBOR
rate (a per annum interest rate) on the maturity day, e.g., 100–100×5.24% = 94.76
※ The notional principal of one contract of Eurodollar futures is $1 million
※ Given the quoted price Z, the value of one Eurodollar futures contract is
$10,000[100 – (90/360)(100 – Z)], e.g., for Z = 94.76, value = $986,900
※ LIBOR rate ↑  quoted price Z ↓  the value of Eurodollar futures ↓ (this
quotation method is more intuitive than quoting LIBOR rate directly)
※ Eurodollar futures contracts expire on the third Wednesday of the delivery month
and are settled in cash (see the example on the next slide)
9-17
Management of Interest Rate Risk
• Illustration for the use of Eurodollar futures:
Date
Quote Price Z
February 10
94.76
February 11
94.23
February 12
94.98
…….
……
March 21
95.10
– On February 10, if you plan to invest $1 million to earn the threemonth interest rate on Mar. 21, you can take a long position of a
Eurodollar futures matured on that day, which can lock in a rate of
(100 – 94.76)% = 5.24%
– On March 21, you can earn 100 – 95.10 = 4.90% on $1 million for
the 3-month lending ($1,000,000×(90/360)×4.90% = $12,250) and
a cash gain on the futures contract of $987,750 – $986,900 = $850
– The sum of $12,250 from the interest income of $1 million and
$850 from the Eurodollar futures is $13,100, which is equal to the
interest income if you lend $1 million at 5.24% for 3 months since
March 21: $1,000,000×(90/360)×5.24% = $13,100
9-18
Management of Interest Rate Risk
• Eurodollar futures strategies for IR exposures:
– Buy a Eurodollar futures contract/long position (for the right
of earning a fixed 3-month interest rate in the future)
• If LIBOR rate ↑, the quoted price and the value of Eurodollar
futures ↓ and investors adopting the long strategy suffers a loss
(offsetting gains on interest income)
• If LIBOR rate ↓, the quoted price and the value of Eurodollar
futures ↑ and the long strategy earns a profit (offsetting losses on
interest income)
– Sell a Eurodollar futures contract/short position (for the
obligation of paying a fixed 3-month interest rate in the
future)
• If LIBOR rate ↑, the quoted price and the value of Eurodollar
futures ↓ and the investor adopting the short strategy earns a profit
(offsetting the higher interest expense)
• If LIBOR rate ↓, the quoted price and the value of Eurodollar
futures ↑ and the short strategy generates a loss (offsetting the
benefit of lower interest expense)
9-19
Exhibit 9.6 Eurodollar Futures
Strategies for Common Exposures
9-20
Management of Interest Rate Risk
• Swaps are contractual agreements to exchange or
swap a series of cash flows
• These cash flows are most commonly the interest
payments associated with debt service, such as the
floating-rate loan of Trident described above
– If the agreement is for one party to swap its fixed interest
rate payments for the floating interest rate payments of
another, it is termed an Interest Rate Swap (IRS), or an
Plain Vanilla Interest Rate Swap
– If the agreement is to swap debt service obligation in
different currencies, it is termed a Currency Swap (or
Cross Currency Swap, CCS) (貨幣交換或換匯換利)
• The swap itself is not a source of capital, but rather
an alteration of the types of the cash flows
associated with payment
9-21
Management of Interest Rate Risk
• The interest rate swap forms the largest single
financial derivatives market in the world
※ This table, which is surveyed
by Bank for International
Settlements (BIS), reports
outstanding amounts of
over-the-counter (OTC)
derivatives from 2007 to
2009
※ Interest rate contracts
remained by far the largest
component of the OTC
market (about 72% of the
total outstanding amount)
※ Note that Eurodollar futures
(or Treasury-bill and
Treasury-bond futures) are
traded on exchanges rather
that in the OTC market
9-22
Management of Interest Rate Risk
• The two parties may have different expectations for
entering into the IRS agreement:
• Motivation 1:
– A firm with fixed-rate debt that expects interest rates to
fall can change fixed-rate debt to floating-rate debt
– In this case, the firm would enter into a pay
floating/receive fixed IRS
• The firm will pay floating interest payments and receive
fixed interest rate payments from the swap counterparty
– The net interest burden of the firm will be a floating
interest rate payment
9-23
Management of Interest Rate Risk
• Motivation 2
– A firm has existing floating-rate debt service payments
and it concludes that interest rates are about to rise
– Through entering into a swap agreement to pay
fixed/receive floating IRS, the net interest burden of the
firm will be a fixed interest rate payment
• Interest rate swaps are contractual commitment
between a firm and a swap dealer (usually a bank)
– The existence of swap dealers can provide the liquidity of
the swap market because it is difficult to find immediately
a counterparty with the different expectation of the change
of interest rates but with the same demand of the principal
and the timing
– Swap dealer can earn the bid-ask spread of the swap rates
9-24
Management of Interest Rate Risk
• Quotations for IRSs
Years
Bid
Ask
Swap Rate
1
5.24%
5.26%
5.250%
2
5.43%
5.46%
5.445%
3
5.56%
5.59%
5.575%
4
5.65%
5.68%
5.665%
5
5.73%
5.76%
5.745%
– The Swap Rate is the fixed rate to let the value of a swap paying
fixed (at that swap rate)/receiving float (at LIBOR) to be zero,
i.e., the present values of the floating rate cash flows and fixed
rate cash flows are equal based on the current LIBOR yield curve
– For a different time to maturity, there is a corresponding swap rate
– Swap dealers quote the bid and ask prices for the swap rate:
• The bid price is the fixed interest rate the dealer will pay for a series
of floating cash inflows at the LIBOR rate, e.g., the dealer would pay
5.56% to exchange for receiving LIBOR rates for three years
• The ask price is the fixed interest rate the dealer needs for a series of
floating cash outflows at the LIBOR rate, e.g., the dealer needs to
9-25
receive 5.59% to exchange for paying LIBOR rate for three years
Exhibit 9.8 Comparative Advantage and
Structuring a Swap Agreement
• Comparative advantage argument: another reason
for the existence of IRSs
※ For Unilever, its comparative advantage over Xerox is 1% (7% vs. 8%) for fixedrate debts and only 0.5% (LIBOR+0.25% vs. LIBOR+0.75%) for floating-rate debts
1. This is because banks usually charge a lower-credit firm a more expensive rate for fixed
rate debts in order to cover its uncertainty in the future
2. For lower-credit firms (like Xerox in this example), they usually prefer fixed-rate debts
because a certain series of cash payments in the future could reduce their financial risk
※ As long as there is a higher-credit firm (like Unilever in this example) preferring a
floating-rate debt, it is possible to share comparative advantages with lower-credit firms
(like Xerox in this example) through IRSs
9-26
Management of Interest Rate Risk
• Interest rate swaps can benefit both counterparties
– Unilever borrows at the fixed rate of 7%
• It prefers a floating-rate debt
• Unilever enters into a receive fixed (7%)/pay floating
(LIBOR) interest rate swap with Citibank
• The net interest rate for Unilever is LIBOR, which is float and
smaller than the original LIBOR+0.25% for floating-rate debts
– Xerox borrows at the floating rate of LIBOR+0.75%
• It prefers a fixed-rate debt
• Xerox enters into a pay fixed (7.875%)/receive floating
(LIBOR+0.75%) interest rate swap with Citibank
• The net interest rate for Xerox is 7.875%, which is fixed and a
lower cost of funds than it could have acquired on its own, i.e.,
8%
※ For Citibank, the net interest rate is 0.125% (=7.875%–7% +
LIBOR–(LIBOR+0.75%))
9-27
Management of Interest Rate Risk
• The swap can be a tool not only for hedge but also
for speculation
– As long as the investor has a expectation of the change of
interest rates, he can trade interest rate swaps, although he
does not have any interest rate exposure
– Expect LIBOR rate ↑, pay fixed/receive floating; Expect
LIBOR rate ↓, pay floating/receive fixed
• The cash flows of an IRS are interest rates applied to
a set amount of capital, which is called notional
principal (名義本金) because it is not exchanged
physically, so IRSs are also known as coupon swaps
9-28
Carlton Corporation:
Swapping to Fixed Rates
• Trident Corporation’s existing floating-rate loan is
now the source of some concern
• Recent events have led management to believe that
interest rates, specifically LIBOR, may be rising in
the three years ahead
• As the loan is relatively new, refinancing is
considered too expensive, but management believes
that a pay fixed/receive floating IRS may be the
better alternative for fixing future interest rates now
• Note that this swap agreement does not replace but
supplement the existing loan agreement
• After considering this IRS, the scheduled interest
rates of the following three year are in Exhibit 9.9
9-29
Exhibit 9.9 Trident Corporation’s Interest
Rate Swap to Pay Fixed/Receive Floating
※ Note that the original floating interest payments (at LIBOR) will be canceled out
with the receipt of floating interest income from the IRS (at LIBOR)
※ If the current fixed borrowing rate quoted to Trident by its lenders is above
7.25%, then it is cheaper to adopt this IRS to change the floating-rate debt
obligation to a fixed-rate debt obligation
9-30
Currency Swap
9-31
Currency Swap
• The usual motivation for the use of a currency swap
is to replace cash flows scheduled in an undesired
currency with cash flows in a desired currency
– Firms often raise capital in currencies in which they do
not possess significant revenues or other natural cash
flows (due to the cheaper cost of fund or lower tax in that
currency)
– The desired currency is probably the currency in which
the firm’s future operating revenues (inflows) will be
generated
※To swap an undesired currency with a cheaper cost of
fund or lower tax for a desired currency with future
operating cash inflows is a possible solution
9-32
Trident Corporation: Swapping Floating
Dollars into Fixed-Rate Swiss Francs
• After raising US$10 million in floating-rate debt, and
subsequently swapping into fixed-rate payments,
Trident decides it would prefer to make its payments
in Swiss francs
– Since the company has a natural cash inflow in Swiss francs
due to sales contract, it may decide to match the currency of
its debt denomination to its cash flows with a currency swap
• Trident now enters into a three-year pay Swiss francs
(at 2.01%) and receive US dollars (at 5.56%)
fixed-for-fixed currency swap
• The cash payments associated with this fixed-forfixed currency swap are shown in Exhibit 9.11
9-33
Exhibit 9.11 Trident’s Currency Swap: Pay
Swiss Francs and Receive U.S. Dollars
pay
receive
receive
receive
receive
pay
pay
pay
※ Different from IRSs, the principal are exchanged physically in currency swaps
– The spot exchange rate on the date of the agreement establishes what the
principal is in the target currency, i.e., the initial exchange rate is SF1.5/US$
and US$10 million is exchanged for SF$15 million initially
– The principal itself is part of the swap agreement because the principals are
exchanged on the initial day and exchanged back on the maturity day
※ For the illustrative purpose, this text book focuses on nonamortizing swaps
which repay the entire principal at maturity, rather than over the life of the swap
agreement
9-34
Interest Rate and Currency Swap
Quotes
• Quotations of the interest rate swaps for different
currencies
• In fact, above quotations are also the quotations for
currency swaps
9-35
Interest Rate and Currency Swap
Quotes
※ In theory, a floating-for-floating currency swap involves exchanging CFs at
LIBOR of one currency for CFs at LIBOR of another currency, e.g., paying
annual LIBOR of US$ and receiving annual LIBOR of SF for three years
(LIBOR of $  LIBOR of SF)
※ Since a swap rate of IRS can exchange for a series of LIBOR rates in each
currency (swap rate  LIBOR for each currency), it allows the fixed-forfixed currency swap to exchange the swap rates in any pair of currencies (swap
rate of $  swap rate of SF), e.g., the 3-year pay Swiss francs/receive US
dollars fixed-for-fixed currency swap is to pay Swiss swap rate 1.97% and
receive US swap rate 5.575%
※ In practice, the swap dealer should charge some fees through the bid and ask
rates in different currencies, and the typical rule of the swap dealer to decide the
bid and ask rates for each currency is to maximize its profit
※ To trade the 3-year pay Swiss francs/receive US dollars currency swap with
Trident, the swap dealer will offer receiving Swiss francs at the ask rate of
2.01% and paying US dollars at the bid rate of 5.56% (those rates are the figures
in the currency swap contract in the case of Trident discussed above)
※ In addition to floating-for-floating and fixed-for-fixed currency swaps, the third
type is a cross-currency interest rate swap where a floating rate (the LIBOR)
in one currency is exchanged for a fixed rate (the swap rate) in another currency 9-36
Mark-to-Market and Unwinding
Swaps
• Financial accounting practices require Trident to track
and value its position regularly with the mark-tomarket (or mark-to-model) method on the basis of
current exchange and interest rates
• After one year, if the two-year fixed rate of interest for
francs (dollars) is now 2% (5.5%) and the spot
exchange rate is now SF1.4650/US$, the market-tomarket value of the fixed-for-fixed currency swap for
Trident is a loss of US$229,818
SF301,500 SF15,301,500

 SF15, 002,912
1
2
(1.02)
(1.02)
US$556, 000 US$10,556, 000
PV($ income) 

 US$10, 011, 078
1
2
(1.055)
(1.055)
SF15, 002,912
mark-to-market value  US$10, 011, 078 
  US$229,818
SF1.4650 / US$
9-37
PV(SF payment) 
Mark-to-Market and Unwinding
Swaps
• It may happen that at some future date one side of a
swap may wish to terminate or unwind the agreement
before it matures
• Unwinding a currency swap requires to close
positions of both counterparties by settling the markto-market gains or losses between them
– For example, if Trident wants to unwind the currency swap
after one year, it needs to pay US$229,818 to the
counterparty
– In practice, the party which wants to unwind the swap will
be charged an additional penalty fee
9-38
Counterparty Risk
• Counterparty risk is the potential exposure any
individual firm bears that the second party to any
financial contract will be unable to fulfill its
obligations under the contract’s specifications
• The real exposure of an interest rate or currency swap
is not the total notional principal, but the “positive”
mark-to-market value of the swap contract
– If the mark-to-market value of the swap contract is negative
for your position, i.e., your counterparty has some gains, it is
not necessary for you to worry about the counterparty risk
• Counterparty risk has been one of the major factors
that favor the use of exchange-traded rather than overthe-counter derivatives
– Exchanges themselves are counterparties to all derivatives
transactions, and together with the margin requirement, there
is nearly no counterparty risk for exchange-traded derivatives 9-39