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Derivative Security Markets: Currency and Interest Rate Swaps
Derivative Security Markets: Currency and Interest Rate Swaps
13-1
Introduction to Swaps
• A capital market swap represents an
agreement to exchange cash flows
between
two parties, usually referred to as
counterparties.
• A swap agreement commits each
counterparty to exchange an amount of
funds, determined by a formula, at regular
intervals until the swap expires.
13-2
• In the case of a currency swap, there is an
initial exchange of currency and a reverse
exchange at maturity.
13-3
Introduction to Swaps
• Like futures and options, a swap is a
derivative security.
• A swap is equivalent to a collection of
forward contracts that call for an exchange
of funds at specified times in the future.
• Like forward contracts, a swap can be used
¤ to speculate,
¤ to hedge an exposure, or
¤ to replicate another security in an effort to
enhance investment returns or to lower
borrowing costs.
13-4
13-5
Introduction to Swaps
• Since a swap can be replicated
using forward contracts, why does the swap
market exist, and why has it grown so
popular?
A swap reduces transaction costs by allowing
the counterparties to combine many
transactions (forward contracts) into one (the
swap).
In addition, the legal structure of a swap
transaction may have advantages that reduce
the risk to each party in the event of a default
by the other party.
13-6
Introduction to Swaps
• The cash flows of a swap were
linked: if firm A could not pay firm B, then
firm B felt excused from having to pay firm
A. Whether swaps always reflect this right-
ofoffset is a critical point.
• In addition, as a new financial product, the
currency swap was not covered by any
accounting disclosure or security
registration requirements.
• We will focus primarily on the economic
fundamentals and financial characteristics
13-7
Introduction to Swaps
of basic interest rate and
currency swap agreements.
13-8
Structure of a Back-to-Back on Parallel
Loan
13-9
Introduction to Swaps
Basic Swap
In the United Kingdom In the Netherlands
British Dutch
parent firm parent firm
Indirect
financing
Direct loan Direct loan
in pounds in guilders
13-10
The Role of Capital Controls
• Suppose a Brazilian affiliate wants to
transfer funds to its U.S. parent firm beyond
what it was allowed to repatriate home. • It
could effectively do so if it made a loan to a
Brazilian affiliate of a French firm and the
French parent simultaneously lent funds to
the U.S. parent.
• Since the legal barrier imposes a cost, the
U.S firm is willing to provide a financial
13-11
incentive to the French firm to take part in
the deal.
Structure of a Back-to-Back on Parallel Loan
Variation
In the United States In Brazil
13-12
French U.S. firm’s
parent firm affiliate in Brazil
Indirect
financing
Direct loan Direct loan
in dollars in cruzados
13-13
The Role of Capital Controls
Though useful, back-to-back and parallel loans
present certain drawbacks :
1 Identifying a counterparty is both time
consuming and costly.
2 Legally, the two loans are separate and distinct.
Hence, one party’s default will not release the
other party from its commitments under the
other loan.
13-14
3 For accounting and regulatory purposes, the
loans are “loans”. Thus, the firm’s borrowing
capacity, credit rating etc can be affected.
13-15
¤ If
A cannot pay B, then B may be excused from
paying A.
• As a new financial product, it was not
covered by any accounting disclosure or
security registration requirements.
each US$
5% 6% -1.0%
issue a 7-year
finance bond in either
13-17
SFr the US$ or finance
13-18
The Basic Cash Flows of a Currency Swap
$ at t 0
SFr at t 0
10.75% (US$)
A B
5.5% (SFr)
13-23
• The total cost for IBM was (Swiss T. + 0bp) +
(U.S. T. + 40bp) - (Swiss T. + 10bp) = U.S. T. +
30bp. So IBM saved 15bp.
• The total cost for the World Bank was (U.S. T. +
40bp) + (Swiss T. + 10bp) - (U.S. T. + 40bp) =
Swiss T. + 10bp. So, the Bank saved 10bp.
Box 13.1 Pg 455
13-24
characteristics. The reasoning is based, in part, on
saturation and scarcity value.
Other things being equal, investors seeking a portfolio
of AAA bonds prefer to hold bonds from a broad set
of issuers in order to diversify the idiosyncratic risks of
any single issuer. An issuer who has not saturated
the market may enjoy a scarcity value and be able to
issue bonds at a lower rate. This effect is more likely
among AAA-rated issuers, given the small universe of
AAA-rated issuers.
13-25
Saturation and scarcity value
13-26
Swiss investors were willing to pay a premium
(reflecting a scarcity value) to bring IBM as a new
AAA-issuer into their portfolios.
13-27
13-28
Interest Rate Swap
Fixed-Rate Payer Floating-Rate Payer
13-29
Interest Rate Swap
In Figure 13.3, we show two firms, A and B, that can
issue a US$ denominated bond in either fixed-rate or
floating-rate terms.
The annual interest costs are assumed to be 9.0%
and 10.5% respectively, for A and B in the fixed-rate
bond market. In addition, each firm can arrange
floating rate financing, perhaps through bank lending
or a commercial paper (CP) program. We assume
that firm A pays six-month LIBOR plus zero basis
points, while firm B pays six-month LIBOR plus 50
basis points.
13-30
This example assumes that interest is paid
semiannually and the floating interest rate is reset
every six months.
The Basic Cash Flows of an Interest Rate Swap
Difference
Firm A Firm B (A-B)
Fixed-
rate 9% 10.5% -1.5% finance
13-31
-1.0%
9.75%
A B
LIBOR + .25
Borrows at Borrows at
9.0% fixed LIBOR + 0.50%
floating
13-33
agreement, plus paying interest on the original bonds
they have issued.
13-34
Thus, A saves 0.50% in relation to its own cost of
floating-rate funds.
How is the value of a swap determined?
13-36
payments, the notional amount, the number of
periods in a year, and the forward discount factor.
The present value of floating-rate payments is also
determined by the notional amount, the number of
periods in a year, and the forward discount factor. It is
also determined by the reference rate (such as
LIBOR) and forward rates based on this benchmark.
It is important to emphasize that the reference rate at
the beginning of period t determines the floating rate
that will be paid for the period. However, the
floatingrate payment is not made until the end of
period t. We should also point out that the same
forward rates that are used to compute the floating-
rate payments— those obtained from the Eurodollar
13-37
CD futures contract—are used in computing the
forward discount factors for each period t.
13-38
Profit and Loss from Entering into an Interest Rate
13-39
Swap When Interest Rates Are Variable
Behavior of Floating Interest Rates
Interest Rates Interest Rates
Rise Relative to Fall Relative to
Expectations Expectations
Speculative Pay floating Speculative loss, Speculative gain,
position and receive swap has negative swap has position
fixed value, out-of-
value, in-the-
themoney swap
money swap
Pay fixed Speculative gain, Speculative loss,
and receive swap has position swap has
floating value, in-the- negative value,
money swap out-of-the-money
swap
Table 13.4 Pg 464
13-40
13-41
Behavior of Short-Term Interest Rates
and the Valuation of Fixed Floating Swap
Valuation Effects for Paying Fixed and Receiving Floating
13-42
Period 1 Period 2 Period 3 Period 4 Period 5
i 5,5 = 5.42
Initial Euro-$
Interest Rate i 5,4 = 5.32
i = 5.22
i 5,3 = 5.22
i 5,2 = 5.12
i 5,1 = 5.02
13-43
The Amortization Effect and the Diffusion Effect
in a Long-Term Interest Rate Swap
Amortization Diffusion
Effect Effect
Time
13-44
The Overall Risk in a Long-Term
Interest Rate Swap
Interaction of
Amortization
and Diffusion
Effect
Time
13-45
Expected Credit Exposures on Interest Rate Swaps:
The Maturity Effect
10
10-year
4
7-year
5-year
2 3-year
1-year
0 4 8 12 16 20
Semiannual Periods
13-46
Figure 13.7A Pg 467
13-47
10
13%
8 11%
9%
6
7%
0 4 8 12 16 20
Semiannual Periods
Figure 13.7B Pg 468
13-48
Swaps & Linkages Across International Capital Markets
Interest Rate Base
Fixed Rate Floating Rate
Currency of Asset or Liability Asset or Liability
Denomination
A Interest Rate Swap B
Cross Interest
Currency Rate Swap
13-50
13-51
An Example of Price Quotations in the Swap Market
13-54
Price Quoting Conventions in the Swap Market
Swap Quotes
Bid Quote Offer Quote
fixed rate
Swap dealer Swap dealer receives pays
floating rate floating rate
13-55
All fixed quotes are against LIBOR unless otherwise stated.
13-56
The relevant prices to use will be the seven-year T-bond
versus LIBOR quotes for US$ interest rate swaps in panel
A, and the Japanese yen cross-currency swap in panel B.
Construction of a Fixed-Fixed Currency Swap
3.10%(¥) 3.14%(¥)
6.67%($) 6.65%($)
Borrows Borrows
fixed-rate fixed-rate
¥ bond at $ bond at
3.80% 7.40%
Table 13.6 Pg 472
13-57
Construction of a Fixed-Fixed Currency Swap
13-58
Construction of a Fixed-Fixed Currency Swap
13-59
Construction of a Fixed-Fixed Currency Swap
13-61
Applications of Swaps: Magnifying Risk and Return
The swaps discussed in the chapter could be termed
“plain vanilla” as the payoffs are governed by the
simple differential between two specific interest rates.
But more exotic swaps could be designed, with
payoffs proportional to twice the interest differential,
or the square of the interest differential.
In principle, these exotic contracts could reduce the
firm’s exposure to risk from its core business
activities. But it is also true that exotic swaps are a
way to enhance speculative return and risk, if these
contracts are not tempered with other hedging
transactions.
13-62
An Unsuccessful Exotic Swap
13-65
An Unsuccessful Exotic Swap
13-66
Assignment from Chapter 13
Exercises 1, 2.
13-67
1. Suppose Firm ABC can issue 7-year bonds in the US at the fixed
rate of 8% and in France at 13%. Suppose Firm XYZ can issue
7year bonds at the fixed rate of 10% in the US in US$ and at
14% in France in FFr.
b. How would you advise both firms so that they take advantage of
each other's comparative advantage in the US and French capital
markets?
c. Total Costs:
ABC Pays 8.0% XYZ Pays 14.0%
13-69
Pays 13.5% Pays 9.0%
Receives 9.0% Receives 13.5%
Net 12.5% Net 9.5%
Savings .5%
.5% Savings
Total Savings: 1%
d. Different comparative advantage for both firms may arise because a
firm's local credit market is saturated with the firm’s debt and would
place value in the availability of debt issues by a foreign firm.
c. What fixed rate in the swap agreement will make the value of
the swap equal to zero?
13-72
Interest Rate Swap (from Fabozzi: Bond Markets, Analysis and Strategies)
For our problem, today’s three-month LIBOR is 5.7%. Thus, the fixed-rate payer
receives payment based on this rate on March 31 of year 1—the date when the first
quarterly swap payment is made. There is no uncertainty about what this floating-rate
payment will be. In general, the floating-rate payment is given as:
In our problem, assuming a non-leap year, the number of days from January 1 of year
1 to March 31 of year 1 (the first quarter) is 90. If three-month LIBOR is 5.7%, then
the fixed-rate payer will receive a floating-rate payment on March 31 of year 1 as
shown below:
(b) Assume the Eurodollar CD futures price for the next seven quarters is as
follows:
1
Number of Days Eurodollar CD
Quarter Starts Quarter Ends in Quarter Futures Price
5.70% × = 1.425%.
Inserting the value for period two (i.e., April 1 year1 to June 30 year 1), we have:
2
1.5333333%, 1.6100%, 1.6000%, 1.6430556%, 1.7377778%, and 1.7888889%.
(c) What is the floating-rate payment at the end of each quarter for this interest-
rate swap?
The floating-rate payment for each period is the forward rate for that period, as given
in the part (b), times the notional amount of $40 million.
1 92
2 92
3 90
4 91
5 92
6 92
7 90
8 91
3
number of days in period
fixed-rate payment = notional amount × swap rate ×
360
where the notional amount is $20 million, the swap rate is 7%, and the number of days
is the number for that period.
(b) Assume that the swap in part (a) requires payments semiannually rather than
quarterly. What is the semiannual fixed-rate payment?
First, we need the days for each of the four semiannual periods for the two years.
Period 1’s days are 92 + 92 = 184. Period 2’s days are: 90 + 91 = 181. Period 3’s days
are: 92 + 92 = 184. Period 4’s days are 90 + 91 = 181.
where the notional amount and swap rate are the same but the number of days change
as given above. Inserting our values, we get for the first period:
4
Similarly, for periods 2, 3, and 4, the respective fixed-rate payments are: $703,888.89,
$715,555.56, and $703,888.89.
(c) Suppose that the notional amount for the two-year swap is not the same in
both years. Suppose instead that in year 1 the notional amount is $20 million, but
in year 2 the notional amount is $12 million. What is the fixed-rate payment
every six months?
The fixed-payments for the first two six-month periods are the same as given in part
(b) as $715,555.56 and $703,888.89. For period 3, the fixed-rate payment is:
16. Given the current three-month LIBOR and the Eurodollar CD futures prices
shown in the table below, compute the forward rate and the forward discount
factor for each period.
Current Eurodollar
Period Days in Quarter 3-month LIBOR CD Futures Price
1 90 5.90%
2 91 93.90
3 92 93.70
4 92 93.45
5 90 93.20
6 91 93.15
5
5.90% × = 1.475%.
Similarly, for periods 3, 4, 5, and 6, the respective forward rates are: 1.6100%,
1.6738889%, 1.7000%, and 1.7315278%.
1 / [(1 + forward rate period 1)(1 + forward rate period 2) . . . (1 + forward rate period
t)].
For period 1, the forward discount factor is:
forward discount factor = 1 / [(1 + forward rate period 1)(1 + forward rate period 2)] =
1 / [(1.01475)(1.015419444)] = 0.97049983.
Similarly for periods 3, 4, 5, and 6, the respective forward discount factors are:
0.95512236, 0.93939789, 0.92369507, and 0.90797326.
6
(a) Suppose that at the inception of a five-year interest-rate swap in which the
reference rate is three-month LIBOR, the present value of the floating-rate
payments is $16,555,000. The fixed-rate payments are assumed to be
semiannual. Assume also that the following is computed for the fixed-rate
payments (using the notation in the chapter):
N
days in period t
swap rate =
present value of floating-rate payments
N
days in period t .
∑
t=1 notional amount× 360 ×forward discount factor for period t
(b) Suppose that the five-year yield from the on-the-run Treasury yield curve is
6.4%. What is the swap spread?
Given the swap rate, the swap spread can be determined. For example, since this is a
five-year swap, the convention is to use the five-year on-the-run Treasury rate as the
benchmark. Because the yield on that issue is 6.40%, the swap spread is 7.00% –
6.40% = 0.6% or 60 basis points.
18. An interest-rate swap had an original maturity of five-years. Today, the swap
has two years to maturity. The present value of the fixed-rate payments for the
remainder of the term of the swap is $910,000. The present value of the floating-
rate payments for the remainder of the swap is $710,000.
7
(a) What is the value of this swap from the perspective of the fixed-rate payer?
The fixed-rate payer (or floating-rate receiver) will receive the floating-rate payments.
These floating-rate payments have a present value of $710,000. The present value of
the payments that must be made by the fixed-rate payer and received by floating-rate
payer is $910,000. Thus, the swap has a negative value for the fixed-rate payer equal
to the difference in the two present values of $710,000 – $910,000 = −$200,000.00.
This is the value of the swap to the fixed-rate payer.
(b) What is the value of this swap from the perspective of the fixed-rate receiver?
The floating-rate payer (or fixed-rate receiver) will receive the fixed-rate payments.
These fixed-rate payments have a present value of $910,000. The present value of the
payments that must be made by the floating-rate payer and received by fixed-rate
payer is $710,000. Thus, the swap has a positive value for the floating-rate payer
equal to the difference in the two present values of $910,000 – $710,000 =
$200,000.00. This is the value of the swap to the floating-rate payer.
10. Suppose that a life insurance company has issued a three-year GIC with a
fixed-rate of 10%. Under what circumstances might it be feasible for the life
insurance company to invest the funds in a floating-rate security and enter into a
three-year interest-rate swap in which it pays a floating rate and receives a fixed-
rate?
If the life insurance can enter a swap that guarantees a satisfactory spread above the
10% it is committed to pay, then it would not only be feasible but desirable to enter
into the swap.
Suppose the life insurance company can enter into a swap with a bank which has a
portfolio consisting of three-year term commercial loans with a fixed interest rate. The
principal value of bank’s portfolio is $10 million, and the interest rate on all its loans
in its portfolio is 11%. The loans are interest-only loans; interest is paid semiannually,
and the principal is paid at the end of three years. That is, assuming no default on the
loans, the cash flow from the loan portfolio is $550,000 million every six months for
the next three years and $10 million at the end of three years (in addition to the $1.1
8
million interest). To fund its loan portfolio, assume that the bank is relying on the
issuance of six-month certificates of deposit. The interest rate that the bank plans to
pay on its six-month CDs is six-month LIBOR plus 40 basis points.
The risk that the bank faces is that six-month LIBOR will be 10.6% or greater. To
understand why, remember that the bank is earning 11% annually on its commercial
loan portfolio. If six-month LIBOR is 10.6%, it will have to pay 10.6% plus 40 basis
points, or 11%, to depositors for six-month funds and there will be no spread income.
Worse, if six-month LIBOR rises above 10.6%, there will be a loss; that is, the cost of
funds will exceed the interest rate earned on the loan portfolio. The bank’s objective is
to lock in a spread over the cost of its funds.
The life insurance company can seize this opportunity to cover its commitment to pay
a 10% rate for the next three years on the $10 million GIC it has issued. The amount
of its GIC is $10 million. Suppose that the life insurance company has the opportunity
to invest $10 million in what it considers an attractive three-year floating-rate
instrument in a private placement transaction. The interest rate on this instrument is
six-month LIBOR plus 160 basis points. The coupon rate is set every six months.
The risk that the life insurance company faces in this instance is that six-month
LIBOR will fall so that the company will not earn enough to realize a spread over the
10% rate that it has guaranteed to the GIC holders. If six-month LIBOR falls to 8.4%
or less, no spread income will be generated. To understand why, suppose that six-
month LIBOR at the date the floating-rate instrument resets its coupon is 8.4%. Then
the coupon rate for the next six months will be 10% (8.4% plus 160 basis points).
Because the life insurance company has agreed to pay 10% on the GIC policy, there
will be no spread income. Should six-month LIBOR fall below 8.4%, there will be a
loss.
We can summarize the asset/liability problems of the bank and the life insurance
company as follows.
Bank:
9
Now let’s suppose the market has available a three-year interest-rate swap with a
notional principal amount of $10 million. The swap terms available to the bank are as
follows:
(i) Every six months the bank will pay 9.45% (annual rate).
(ii) Every six months the bank will receive LIBOR.
(i) Every six months the life insurance company will pay LIBOR.
(ii) Every six months the life insurance company will receive 9.40%.
What has this interest-rate contract done for the bank and the life insurance company?
Consider first the bank. For every six-month period for the life of the swap agreement,
the interest-rate spread will be as follows:
Thus, whatever happens to six-month LIBOR, the bank locks in a spread of 155 basis
points.
Now let’s look at the effect of the interest-rate swap from the perspective of the life
insurance company:
10
From floating-rate instrument 1.6% + six-month LIBOR
From interest-rate swap 9.40%
Total 11.00% + six-month LIBOR
Annual Interest Rate Paid:
To GIC policyholders 10.00%
Six-month LIBOR On
10.00% + six-month LIBOR interest-
rate swap
Outcome:
Total
To be received 11.00% + six-month LIBOR
To be paid 10.00% + six-month LIBOR
The interest-rate swap has allowed each party to accomplish its asset/liability
objective of locking in a spread.
It permits the two financial institutions to alter the cash flow characteristics of its
assets: from fixed to floating in the case of the bank, and from floating to fixed in the
case of the life insurance company.
11