Interest rate and currency swaps

When multinationals face interest rate risk, they adopt these strategies

Types of swaps

• In interest rate swap financing, two parties, called counterparties, make a contractual agreement to exchange cash flows at periodic intervals.

• There are two types of interest rate swaps– Single currency interest rate swap (interest rate

swap)– Cross-currency interest rate swap (currency swap)

Interest rate swap

• A plain vanilla IRS – A fixed-for-floating rate swap

• A quality spread differential (QSD) is the difference between default-risk premium differential on the fixed-rate debt and the default-free risk premium differential on floating-rate debt.

Calculation of QSDCompany B Bank A Differential

Fixed-rate 11.25% 10.00% 1.25%

Floating-rate LIBOR + 0.50% LIBOR 0.50%

QSD 0.75%

Fixed-for-floating IRSIssue Eurodollar Bonds @ 10%

BANK AAAA UK

Issue FRN in $ @ LIBOR - 0.375%

Swap Bank Company B

BBB US

= =

10.375% 10.50%

LIBOR LIBOR

10%

Issue domestic Bonds @ 11%

Issue FRN in $@ LIBOR + 0.50%

Company B Bank A DifferentialFixed-rate 11.25% 10.00% 1.25%

Floating-rate LIBOR + 0.50% LIBOR 0.50%

QSD 0.75%

Currency SwapGerman MNC US MNC Differential

Dollar loan 9% on $ 8% $ 1%

Euro loan 6% on Euro 7% Euro 1%

2%

In interest rate swap, we took the difference of difference; here we are takingaddition of difference.

• The process of a currency swap is the following:– At beginning, exchange principals– At the end of each period, exchange interest for

the borrowed currency– At the end of the swap, return principals

Currency Swap (principals exchanged)USCapital MarketUSD loan @ 8%

US MNC

Swap Bank

German Capital marketEuro loan @ 6%

GermanMNC

$ 1 mln

€ 0.8 mln € 0.8 mln

$1mlnIssue bond

Receive E0.8 mln

$1mln

Spot rate: E0.80/$

Issue bond

€ 0.8 mln

German companyIn US

US company in Germany

Currency Swap (interest payments)USCapital MarketUSD loan @ 8%

US MNC

Swap Bank

German Capital marketEuro loan @ 6%

GermanMNC

$ @ 8% on 1mln

€ @ 6.10% € @ 6% on 0.8 mln

$ @ 8.15%

Comparative Advantage: Example

Example• Suppose the American and British companies have

access to both British (BP) and American ($) lending markets.

• Suppose the American company is more creditworthy and can obtain lower rates than the British company in both the US and British markets.

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Comparative Advantage: Example

Example: • Suppose the American company can obtain 10%

U.S. dollar-denominated loans in the U.S. market and 7.25% sterling-denominated loans in the British market, whereas the best the British company can obtain is 11% in the U.S. market and 7.5% in the British market

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Comparative Advantage: Example

Loan Rates for American and British Companies in Dollars and Pounds

Spot: E0 = $/£ = $1.50/£ Dollar Market

(rate on $) Pound Market

(rate on £)American Company

British Company10%11%

7.25%7.5%

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Example• The American company has a comparative advantage in

the US market: – It pays 1% less than the British company in the US

market, compared to only .25% less in the British market.

• The British company has a comparative advantage in the British market: – It pays .25% more than the American company in the

British market, compared to 1% more in the US market.

Comparative Advantage: Example

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Comparative Advantage: Example

• When a comparative advantage exist, a swap bank is in a position to benefit one or both parties.

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Comparative Advantage: Example

Example:• Suppose in this case a swap bank sets up the following

swap arrangement: 1. The American company borrows $150 million at

10%, and then agrees to swap it for £100 million loan at 7%.

2. The British company borrows £100 million at 7.5%, and then agrees to swap it for $150 million loan at 10.6%.

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Comparative Advantage: Example

• The next three exhibit slides show the initial swap of the principals, annual cash flows of interest, and final exchange of the principals.

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Comparative Advantage: Example

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(a) Initial Cash Flow

BondholderBritish

CompanyBritish

AssetAmericans'CompanyBritish

m100£

BondholderAmerican

CompanyAmerican

AssetBritishs'CompanyAmerican

m150$BankSwap

m150$

m150$

m150$

m100£

m100£

m100£

Comparative Advantage: Example

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(b) Annual Interest Cash flow

BondholderBritish

CompanyBritish

AssetAmericans'CompanyBritish

£7m)07)(.m100(£

BondholderAmerican

CompanyAmerican

AssetBritishs'CompanyAmerican

BankSwap

m9.15$)150)($106(.

£7.5m)075)(.m100(£

£7.5m

m15$)m150)($10(.

£7.5m

m9.15$

m15$

Comparative Advantage: Example

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(c) Principal Payment at Maturity

BondholderBritish

CompanyBritish

AssetAmericans'CompanyBritish

m100£

BondholderAmerican

CompanyAmerican

AssetBritishs'CompanyAmerican

m150$BankSwap

m150$

m150$

m150$

m100£

m100£

m100£

Comparative Advantage: Swap Bank’s Position

• In this swap arrangement:– The American company benefits by paying 0.25%

less than it could obtain by borrowing British pounds directly in the British market

– The British company gains by paying 0.4% less than it could obtain directly from the U.S. market.

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Comparative Advantage: Swap Bank’s Position

• The swap bank in this case will receive $15.9 million each year from the British company, while only having to pay $15 million to the American company, for a net dollar receipt of $ 0.9 million.

• On the other hand, the swap bank will receive only £7 million from the American company, while having to pay £7.5 million to the British company, for a net sterling payment of £0.5 million.

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Comparative Advantage: Swap Bank’s Position

Swap Bank’s Position:

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Swap Bank’s $ Position

Receives: (.106)($150,000,000) = $15,900,000Pays: −(.10)($150,000,000) = −$15,000,000Net $ Receipt: $900,000

Swap Bank’s £ Position

Receives: (.07)(£100,000,000) = £7,000,000Pays: (.075)(£100,000,000) = −£7,500,000 Net £ Payment: −£500,000

Comparative Advantage: Swap Bank’s Position

• Thus, the swap bank has a position equivalent to a series of long currency forward contracts in which it agrees to buy £500,000 for $900,000 each year. The swap bank's implied forward rate on each of these contracts is $1.80/£:

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£80.1$

000,500£000,900$E f

Comparative Advantage: Swap Bank’s Position

• The swap bank can hedge its position with currency forward contracts.

• If the forward rate is less than $1.80/£, then the bank could gain from hedging the swap agreement with forward contracts to buy £500,000 each year each year for the next five years.

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Comparative Advantage: Swap Bank’s Position

• For example, suppose the yield curves applicable for the swap bank are flat at 9.5% in the U.S. dollars and 7% in pounds (assume annual compounding). Using the interest rate parity relation, the one-, two-, three-, four-, and five-year forward exchange rates would be:

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T

BP

$0fT R1

R1EE

£/683616.1$07.1095.1)£/50.1($E:5T

£/645177.1$07.1095.1)£/50.1($E:4T

£/607616.1$07.1095.1)£/50.1($E:3T

£/570912.1$07.1095.1)£/50.1($E:2T

£/535047.1$07.1095.1)£/50.1($E:1T

5

f

4

f

3

f

2

f

1

f

Comparative Advantage: Swap Bank’s Position

• The swap bank could enter into forward contracts to buy £500,000 each year for the next five years at these forward rates.

• With all of the forward rates less than implied forward rate of $1.80/£, the bank’s dollar costs of buying £500,000 each year would be less than its $900,000 annual inflow from the swap.

• By combining its swap position with forward contracts, the bank would be able to earn a total profit from the deal of $478,816.

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Comparative Advantage: Swap Bank’s Hedge

• Swap Bank’s Hedged Position

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1 2 3 4 5 6Year $ Cash Flow £ Cash Flow Forward Exchange: $/£ $ Cost of Sterling Net $ Revenue

Column (2) X Column (3) Column (4) X Column (3) Column (2) - Column (5)1 $900,000 £500,000 $1.535047 -$767,524 $132,4772 $900,000 £500,000 $1.570912 -$785,456 $114,5443 $900,000 £500,000 $1.607616 -$803,808 $96,1924 $900,000 £500,000 $1.645177 -$822,589 $77,4125 $900,000 £500,000 $1.683616 -$841,808 $58,192

$478,816

Comparative Advantage: Swap Bank’s Hedge

• Instead of forward contracts, the swap bank also could hedge its swap position by using a money market position.

• For example, on its first sterling liability of £500,000 due in one year, the bank would need to create a sterling asset worth £500,000 one year later (current value of £467,290M = £500,000/1.07) and a dollar liability worth $764,524 (based on the forward contract).

• The bank could do this by borrowing $700,935 (= ($1.50/£) (£467,290)) at 9.5%, converting it to £467,290, and investing the sterling at 7% interest for the next year.

• One year later, the bank would have £500,000 (= £467,290(1.07)) from the investment to cover its sterling swap liability and would have a dollar liability of $767,524 (= $700,935(1.095)), which is less than the $900,000 dollar inflow from the swap.

• The bank would thus earn a profit of $132,476 (= $900,000 −$767,524) from the hedged cash flow – the same profit it would earn from hedging with the forward exchange contracts if the interest rate parity relation holds.

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Summary

• The presence of comparative advantage creates a currency swap market in which swap banks look at the borrowing rates offered in different currencies to different borrowers and at the forward exchange rates and money market rates that they can obtain for hedging.

• Based on these different rates, they will arrange swaps that provide each borrower with rates better than the ones they can directly obtain and a profit for them that will compensate them for facilitating the deal and assuming the credit risk of each counterparty.

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