Currency and Interest

Rate Swaps

10

Chapter Ten

Chapter Objective:
This chapter discusses currency and interest rate swaps,
which are relatively new instruments for hedging longterm interest rate risk and foreign exchange risk.

Chapter Outline:
Types of Swaps

Size of the Swap Market

The Swap Bank
Interest Rate Swaps
Currency Swaps
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Swap Market
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

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The Swap Bank

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.

Interest Rate Swap

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).

Interest Rate Swap

Each party will issue the less advantageous form of debt.
Swap
Bank

Pay floating

Company A
prefers floating
Issue fixed

Receive
fixed

Pay fixed

Receive
Floating

Company B
prefers fixed
Issue floating

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:

The Quality Spread Differential

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.
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An Example of an Interest Rate Swap

Swap
10.50%

Bank

LIBOR

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

Bank
A
Issue $10M debt
at 10% fixed-rate

COMPANY
Fixed rate
Floating rate

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

An Example of an Interest Rate Swap

0.50% of $10,000,000
= $50,000. Thats
quite a cost savings
per year for 5 years.

Heres whats in it for Bank A:

Bank A can borrow externally
at 10% fixed and have a net
borrowing position of

Swap

10.50%

Bank

-10.50% + 10% + LIBOR =

LIBOR

Bank
10%

LIBOR 0.50% which is 0.50

% better than they can borrow
floating without a swap.

A
COMPANY
Fixed rate
Floating rate

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

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
10.75%
LIBOR

Company
B
Issue $10M debt at
LIBOR+0.50% floating-rate
COMPANY

Fixed rate
Floating rate

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

10

An Example of an Interest Rate Swap

0.5 % of $10,000,000 =
$50,000 thats quite a cost
savings per year for 5
years.

Swap
Heres whats in it for Firm B:
Firm B can borrow externally at
LIBOR + .50 % and have a net
borrowing position of

Bank

10.75%
LIBOR

Company

10.75 + (LIBOR + .50 ) - LIBOR = 11.25% which

is 0.50 % better than they can borrow floating
(11.75%).
COMPANY
Fixed rate
Floating rate

LIBOR
+ .50%

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

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An Example of an Interest Rate Swap

The swap bank makes
money too.
10.50%
LIBOR

.25% of $10 million =

$25,000 per year for 5
years.

Swap
Bank

10.75%
LIBOR

Bank
A

Company
LIBOR+10.75% LIBOR-10.50%=0.25%

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An Example of an Interest Rate Swap

The swap bank makes .25%
Swap
10.50%

Bank
10.75%

LIBOR

LIBOR

Bank
A
A saves .50%
Fixed rate
Floating rate

Company

COMPANY

B
B saves .50%

BANK A

11.75%

10%

LIBOR + .5%

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

LIBOR

8%

-(LIBOR+.25)

Swap Dealer w/A

7.75%

LIBOR

Company B

8.25%

LIBOR

Swap Dealer w/B

LIBOR

8.5%

Swap Dealer Net

LIBOR+7.75%

LIBOR+8.25%

-8.75%
+0.50%

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Currency Swaps

Most often used when companies make crossborder capital investments or projects.
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.
Options:

1.

2.

3.

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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Currency Swaps
Typically, a company should have a comparative
advantage in borrowing locally
Pay foreign

Company
A local
issue
Issue local

Swap
Bank
Receive
local

Receive
local

pay foreign

Company
B local
issue
Issue local

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An Example of a Currency Swap

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 S0($/ ) = $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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An Example of a Currency Swap

Consider two firms A and B: firm A is a U.S.based multinational
and firm B is a Germanybased multinational.
Both firms wish to finance a project in each others country of the
same size. Their borrowing opportunities are given in the table
below.

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An Example of a Currency Swap

Annual
Interest
$4.16M
$8%
6%
$8%

Firm

Borrow
$52M

Annual
Interest
2.4 M

Swap
Bank

Annual
Interest
$4.16M
$8%
6%
Annual
Interest
2.4 M

Firm
B

6%
Borrow
40M

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An Example of a Currency Swap

As net position is to
borrow at 6%

Swap
Bank

$8%
6%
$8%
$52M

Bs net position is to
borrow at $8%
$8%
6%

Firm

Firm

6%
40M

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Swap Market Quotations

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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Risks of Interest Rate

and Currency Swaps
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 dealerthe risk that a counter party
will default on its end of the swap.
Mismatch Risk
Its 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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