Admin News
 Final’s date: 60% liked 12/18 (Registrar-set date) .
 => So, final will be 12/18.
 Some of you had emergency reasons & wound not be able to
make it => expect an email from me.
 Quiz V next Tuesday…
 If absolutely can’t come, please let me know…
 Will try to accommodate you .
 Otherwise, weight goes to final
1
Swaps
(or parts of chapter 14)
2
Agenda
 Interest rate risk?
• Credit & Repricing risks
 What hedging strategy?
•
•
•
•
•
Refinancing
Forward Rate Agreement
Interest Rate Future
Interest Rate Swap
Currency Swap (& how to undo them)
 Counterparty Risk
 Cross Currency Swaps (again )
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Interest Rate Risk
 Fact: all firms sensitive to interest rate changes.
 MNE: differing currencies have differing interest
rates => interest rate risk larger!
 Reference rate
• rate of interest used in standardized quotation, loan
agreement, or financial derivative valuation
• Most common: LIBOR (London Interbank Offered
Rate).
4
Credit and Repricing Risk
 Credit (roll-over ) Risk: risk of change of borrower
creditworthiness when renewing credit.
 Repricing risk: risk of changes in interest rates charged
(earned) when financial contract rate is reset.
 For Example: three debt strategies
• #1: Borrow $1 million for 3 years @ fixed rate.
• #2: Borrow $1 million for 3 years @ floating rate, LIBOR + 2%
reset annually.
• #3: Borrow $1 million for 1 year @ fixed rate, renew credit
annually
5
How to hedge floating-rate loans risk?
 Assume floating-rate loan for US$10 m.
 Serviced w/ annual payments
 Bullet principal payment @ end third year
• Loan priced @ US$ LIBOR + 1.50%.
• LIBOR reset annually.
• At time 0, up-front fee of 1.50%.
• Do we know the actually cost?
6
Floating-Rate Loan: Example
3-year $10,000,000 floating rate loan
Loan Interest Rate
LIBOR
Spread
Total
Interest Cash Flows
LIBOR
Spread
Total
Loan Proceeds
Total Loan cash flow
Year 1
Year 2
Year 3
5%
5%
1.50%
6.5%
5%
1.50%
6.5%
5%
1.50%
6.5%
Year 0
Year 1
($500,000)
(150,000)
($650,000)
Year 2
($500,000)
(150,000)
($650,000)
$9,850,000
$9,850,000
($650,000)
Year 3
($500,000)
(150,000)
($650,000)
($10,000,000)
($650,000) ($10,650,000)
7.07%
IRR of total cash flow
Sensitivity to LIBOR
Baseline case
LIBOR up 25 bp/year
LIBOR down 25 bp/year
Year 0
All-in-Cost
A-I-C
7.07%
7.57%
6.58%
LIBOR (yr. 0) LIBOR (yr. 1) LIBOR(yr. 2) LIBOR (yr. 3)
5%
5%
5%
5%
5.75%
5.50%
5.25%
5%
4.25%
4.50%
4.75%
5%
7
How to manage a floating rate loan?
 Alternatives
• Refinancing –refinance the entire agreement.
• Forward Rate Agreement (FRA) –lock in future
interest rate payment (as w/ forex forward contracts).
• Interest Rate Futures
• Interest Rate Swaps –Could swap floating rate note for
fixed rate note w/ swap dealer.
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Forward Rate Agreement (FRA)
 Interbank-traded contract to buy or sell interest rate payments
on notional principal.
• E.g.: If you wish to lock in first payment, buy a FRA which
locks total interest payment @ 6.5%
– If LIBOR above 5% => receive cash payment from FRA seller
reducing LIBOR payment to 5%
– If LIBOR below 5% => pay FRA seller cash amount increasing
LIBOR payment to 5%
– So you locking in payment of 5%+1.5%!
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Interest Rate Futures
 Very often used (unlike forex futures)
• high liquidity of interest rate futures markets
• standardized interest rate exposures firms
 Exchange-traded
• Chicago Mercantile Exchange (CME).
• Chicago Board of Trade (CBOT).
• London Intl Financial Futures & Options Exchange (LIFFE).
 Yield calculated from settlement price
Exposure Action
Paying
interest
Short
future
Interest
Rate
Rates up
Rates down
Earning
interest
Long
future
Rates up
Rates down
Outcome
Pfutures down (long: loss)
Pfutures up (long: profit)
Pfutures down (short: profit)
Pfutures up (short: loss)
10
Eurodollar Futures (3 month), 11/19/03
Source: WSJ, 11/20/03
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Interest Rate & Currency Swaps
 Contractual agreements to exchange (swap) series of cash
flows.
 Commits each counterparty to exchange amount of funds, @
regular intervals, until expiration.
 Interest rate swap: agreement to swap fixed interest payment
for floating rate payment.
 Currency swap: agreement to swap currencies of debt service
=> initial currency exchange & reverse @ maturity.
 Swap may combine elements of both interest rate and currency
swap.
 Swap itself not source of capital!
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Interest Rate Swaps Strategies
 Swap = collection of forward contracts for exchange of funds
@specified maturities.
• reduces transaction costs.
• legal structure of swap transaction reduce counterparty risk.
 Interest rate swap cash flows: interest rates applied to a
notional principal, but no principal is swapped!
Position
Fixed-Rate Debt
Expectation
Rates up
Rates down
Floating-Rate Debt Rates up
Rates down
Strategy
Stay put
Pay floating/Receive Fixed
Pay fixed/Receive floating
Stay put
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Example: swapping to fixed rates
 Expect rates will rise over life of loan.
 => interest rate swap pay fixed/receive floating would be best.
 Bank quotes you 5.75% against LIBOR
 The swap does not replace the original loan, must still make
payments at original rates!
 Swap only supplements the loan payments!
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Interest Rate Swap
Loan Interest Rate
Variability
Year 1
Year 2
Year 3
LIBOR
Spread
Total
Floating
Fixed
-5.00%
-1.50%
-6.50%
-5.00%
-1.50%
-6.50%
-5.00%
-1.50%
-6.50%
Swap Cash Flows
Pay fixed
Receive floating LIBOR
Variability
Fixed
Floating
Year 1
-5.75%
5.00%
Year 2
-5.75%
5.00%
Year 3
-5.75%
5.00%
Loan & Swap Position
LIBOR on loan
Spread (fixed)
Pay fixed on swap
Receive floating LIBOR
Net interest due after swap
Variability
LIBOR (yr. 1) LIBOR(yr. 2) LIBOR (yr. 3)
Paying
-5.00%
-5.00%
-5.00%
Paying
-1.50%
-1.50%
-1.50%
Paying
-5.75%
-5.75%
-5.75%
Receiving
5.00%
5.00%
5.00%
Net Payment
-7.25%
-7.25%
-7.25%
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Currency Swap
 So far, raised $10m in floating rate financing & swap into
fixed rate payments.
 But, may prefer to make debt-service payments in SF.
 => would enter into a 3-year pay Swiss francs & receive US$
swap
• Both interest rates fixed.
• Will pay 2.01% (ask rate) fixed SF interest & receive 5.56%
(bid rate) fixed US$.
 Spot rate on date of agreement establishes notional principal is
in target currency
• Notional amount of SF 15,000,000.
• Commit to payments SF 301,500 (2.01%  SF15,000,000)
• The notional amounts part of swap agreement!
16
Currency Swap
Source: Financial Times (as quoted by MSE)
17
Swapping US$ to Swiss Francs
18
Unwinding Swaps
 Can unwind a swap if viewpoints changes…
 Assume 3-year contract w/ Swiss buyer terminates in
one year
 How to unwind it?
• Discount remaining cash flows under swap agreement
@ current interest rates.
• Convert target currency back to home currency
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Unwinding Swaps
 Assume two payments left: SF301,500 & SF15,301,500
 2-year fixed rate for SF is 2%
 PV swap commitment 301,500 15,301,500
1
(1.020)

(1.020)
2
 SF15,002,912
 PV of remaining cash flows on the $-side of swap is determined
using current 2 year fixed dollar rate 5.5%
$556,000 $10,556,000
PV(US$) 

 $10,011,078
1
2
(1.055)
(1.055)
 PV net inflows $10,011,078.
 PV net outflows SF 15,002,912.
 If current spot SF 1.465/$ net settlement
Sfr15,002, 912
Settlement  $10,011,078 
 ($229,818)
Sfr1.4650/ $
20
Counterparty Risk
 Potential exposure any firm bears that second party to
financial contract will be unable to fulfill obligations.
 A firm entering into a swap agreement retains the
ultimate responsibility for its debt-service.
 In event swap counterpart defaults, payments would
cease.
 The real exposure: not total notional principal, but
mark-to-market value of differentials!
21
3-way Cross Currency Swap
Sometimes firms enter into loan agreements w/ swap already in mind,
creating debt issuance coupled w/ swap from inception…
Province of Ontario
C$300
million
C$150
million
(Canada)
$260
million
Borrows $390 m
@ US Treasury + 48 b.p.
$130
million
(Finland)
Inter-American
Development Bank
Borrows C$300 million
@ Canadian Treasury + 47 b.p.
Borrows C$150 million
@ Canadian Treasury + 44 b.p.
Finish Export Credit
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Things to remember…
 Interest rate risk?
• Credit & Repricing risks
 What hedging strategy?
•
•
•
•
•
Refinancing
Forward Rate Agreement
Interest Rate Future
Interest Rate Swap
Currency Swap (& how to undo them)
 Counterparty Risk.
 Cross Currency Swaps.
23