Interest Rate & Currency

Swaps (ch14)

Learning Objectives
Swap market and swap bank
Interest rate swaps
Currency swaps
Pricing interest rate and currency swaps
Risk of interest rate and currency swaps
Swap market efficiency

Definition
In a swap, two counterparties agree to a contractual arrangement
wherein they agree to exchange cash flows at periodic intervals.
Two types of interest rate swaps:
Single currency interest rate swap
One counterparty exchanges the interest payments of one debt
obligation for the interest payments of another debt obligation.
The periodic cash flows are in the same currency.
Typically shortened as interest rate swap
Basic (plain vanilla) interest rate swap: fixed-for-floating swap
Cross-currency interest rate swap
One counterparty exchanges the debt service obligation
denominated in one currency for the debt service obligation of
the other counterparty denominated in another currency.
Often shortened as currency swap
Basic currency swap: fixed-for-fixed swap
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Swap Market
Size of the swap market: measured by notional principal, a
reference amount for determing interest payments
The most common currencies used to denominate swaps:
U.S. dollar
Japanese yen
Euro
Swiss franc
British pound sterling

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 market maker
(dealer).
As a broker, the swap bank charges commissions to match
counterparties but does not take any side of the swap.
As a market maker, the swap bank stands ready to be either
side of the swap, and then later lays off its risk, or matches it
with a counterparty.
By acting as either side of the swap, the swap bank takes
certain risks.

Swap Market Quotations

Swap banks can tailor the terms of interest rate or currency swaps
to customers needs.
Swap banks also make a market in generic plain vanilla swaps
and provide quotations applicable to counterparties with Aa or
Aaa credit ratings.
It is a convention for swap banks to quote:
Interest rate swap rates against a local standard reference in
the same currency.
Currency swap rates against U.S. dollar LIBOR flat.
flat means no credit premium

Interest Rate Swap Quotations

Euro-
Bid

Ask

Sterling
Bid

Ask

Swiss franc

U.S. $

Bid

Ask

Bid

Ask

1 year

2.34

2.37

5.21

5.22

0.92

0.98

3.54

3.57

4 year

3.06

3.09

5.12

5.17

1.73

1.81

4.25

4.28

5 year

3.23

3.26 The5.11
5.16
swap bank
will

1.93

2.01

4.37

4.39

6 year

3.38

pay fixed-rate
at2.18
4.75% against
3.41 (1) 5.11
5.16 $ payments
2.10
4.46 receiving
4.50 fixed-rate

7 year

3.52

3.55

8 year

3.63

3.66

9 year

3.74

3.77

10 year

3.82

3.85

The swap bank will

2 year 2.62
2.65
5.14
5.18
1.23
1.31
3.90
3.94
(1) pay fixed-rate euro payments at 3.82% against receiving euro LIBOR payment
2.89euro5.13
1.58 euro4.11
(2)3 year
receive2.86
fixed-rate
payments5.17
at 3.85%1.50
against paying
LIBOR 4.13
payment

SF payment
5.10
5.15at 2.64%
2.25

2.33

4.55

4.58

5.09

5.14

2.48

2.56

4.70

4.72

5.08

5.13

2.56

2.64

4.75

4.79

(2) receive fixed-rate $ payments at 4.79% against paying fixed-rate

5.10
5.15
2.37
2.45
4.62
4.66
SF payment at 2.56%

Interest Rate Swap: an Example

Bank A is a AAA-rated international bank located in U.K.. It plans to
raise $10,000,000 to finance a 5-year, floating-rate Eurodollar loan
issued to its customer.
Bank A has two options to raise $10, 000, 000:
Issue 5-year fixed-rate Eurodollar bonds at 10%
Issue 5-year floating-rate notes (FRNs) indexed to LIBOR
Bank A prefers the floating-rate borrowing due to the floatingrate loan issued to its customers.
Firm B is a BBB-rated U.S. company. It needs $10,000,000 to
finance a 5-year project.
Firm B has two financing options:
Issue 5-year fixed-rate bonds at 11.25% in the U.S. bond market.
Issue 5-year FRNs at LIBOR + 0.5%.
Firm B would prefer to borrow at a fixed rate.
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Interest Rate Swap Via the Swap Bank

The borrowing costs of the two firms:

Fixed Rate

B
(Prefers fixed
rate)

A
(Prefers floating
rate)

11.25%

10%

Floating Rate LIBOR+0.5%

LIBOR

The swap bank makes a market for 5-year plain-vanilla swaps

at 10.375-10.50 against dollar LIBOR.

Swap by Bank A
Bank A will do the followings:
Issue 5-year fixed-rate bonds to raise $10 million at 10% (which
is not what A prefers)
Swap:
Make LIBOR payment (LIBOR on $10 million) to the swap
bank.
Receive fixed-rate payment (10.375% on $10 million) from
the swap bank.
Net Result:
Bank A converts its fixed-rate debt into floating-rate debt at an
all-in cost (AIC) lower than the floating rate it could arrange on
its own.

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The All-in Cost (AIC) for Bank A

Swap

The all-in cost for Bank A:

10% + LIBOR -10.375%=LIBOR

Bank 0.375%, which is 0.375 % lower than
what A can borrow floating-rate loan at
10.375%
on its own.
cost savings per year: 0.375% (37.5bps)
LIBOR
10%

Bank
A

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Swap by Firm B
Firm B will do the followings:
Issue 5-year floating-rate notes to raise $10 million (which is
not what B prefers)
Swap:
Make fixed-rate payment (10.5% on $10 million) to the swap
bank.
Receive LIBOR payment (LIBOR on $10 million) from the
swap bank.
Net result:
Company B converts its floating-rate debt into fixed-rate debt
at an all-in cost (AIC) lower than the fixed rate it could arrange
on its own.

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The All-in Cost (AIC) for Company B

Swap
The All-in Cost for Company B:

Bank

10.5% + (LIBOR + 0.5%) - LIBOR =

11%, which is 0.25% lower than what
B can borrow at fixed-rate on its own.

cost savings per year: 0.25% (25bps)

10.5%
LIBOR

Company
B

LIBOR
+ 0.5%

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Profit Earned by the Swap Bank

The swap bank makes money too!

10.5% - 10.375% =0.125% (12.5bps)

per year for 5 years

Swap
10 3/8%
LIBOR

Bank
10 %
LIBOR

Bank

Company

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Comments on Interest Rate Swap

Benefits of using interest rate swaps
To better match the maturities of assets and liabilities
To obtain a cost saving on borrowing
The principals of the debts are not exchanged.
In practice, only the net difference of interest payments is
exchanged.

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Quality Spread Differential (QSD)

QSD=Default Risk Premium (DRP) differential on Debt #1 (e.g. the
fixed-rate debt) minus DRP differential on Debt #2 (e.g. the
floating-rate debt)
QSD represents the potential gains from the swap shared by two
counterparties and the swap bank.
There is no reason to presume that the gains will be shared
equally.
In general, less credit-worthy firm would get less of the QSD to
compensate the swap bank for the default risk.
A positive QSD is the necessary condition for a swap to be
possible.

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How QSD is Shared

The swap bank earns 0.125% (12.5bps)
Swap
Bank
10.375%
LIBOR

10.5%
LIBOR

Bank

Company

A saves 0.375% (37.5 bps)

B saves 0.25% (25 bps)

QSD=(11.25%-10%) -(LIBOR+0.5%-LIBOR)
QSD=0.75%=75bps
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Risks for the Swap Bank

Credit risk: a counterparty will default on its payment.
This is the major risk faced by a swap bank.
Interest rate risk:
Interest rates may change unfavorably before the swap bank can lay off
the swap it undertakes with one counterparty.
Mismatch risk
Its hard to find an exact match for a swap the swap bank has agreed to
take.
The mismatch may be with respect to the size of the principals, the
maturity dates or the debt service dates.
Basis risk
When the floating rates are not pegged to the same index, the swap bank
may pay more than it receive if the indexes are not perfectly correlated.
Exchange rate risk (for currency swap)
Sovereign risk (for currency swap):
The government imposes exchange rate restrictions on a currency
involved in a swap.

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Currency Swap: an Example

A U.S. MNC and a German MNC have a mirror-image financing
need:
Both plan to raise funds to finance a 5-year project by its
foreign subsidiary:
The German MNC needs to raise $52,000,000.
The U.S. MNC needs to raise the equivalent amount in at
the current spot rate $1.3/ (i.e. 40,000,000).
Both MNCs are of the same creditworthiness.
Because both MNCs are less well-known outside their domestic
capital market, they have to pay higher interest rate if they
borrow foreign currency in the international bond market:
The U.S. MNC pays 8% in $ borrowing but 7% in borrowing.
The German MNC pays 6% for borrowing but 9% for $
borrowing.
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Challenges for the MNC

If the parent firm raises money in domestic capital market to
finance its foreign projet:
A long-term transaction exposure to foreign currency risk will be
created.
E.g. if $ appreciated substantially against the over 5-year
period, U.S. MNCs German subsidiary may not earn enough
to service the dollar loan.
If the parent firm raises money (denominated in foregin currency)
in intertional bond market, it has to borrow at a disadvantageous
rate.
Solution: use currency swap to restrcture financing and mitigate
risks.

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Cash Flows Result from the Currency

Swap
Assume bid-ask spread is zero
5-year $ swaps at 8.00-8.00 percent against $ LIBOR
5-year swaps at 6.00-6.00 percent against $ LIBOR
A 5-year currency swap can be arranged by the swap bank as follows:
First, both MNCs raise funds in their domestic capital markets and then swap the
principals with the swap bank:
The German MNC borrows 40,000,000 at 6% and swaps the amount for
$52,000,000.
The U.S. MNC borrows $52,000,000 at 8% and swaps the $ amount for 40,000,000.
Every year, each MNC pays and receives interests based on the term of the swap contract
it entered into:
The German MNC pays $4,160,000 and receives 2,400,000
The US MNC receives $4,160,000 and pays 2,400,000
The FC interest payments will be covered by the money earned by their foreign
subsidiaries.
On debt retirement date (maturity date), the principals are swapped back so that both
MNCs can pay off the debts raised in their domestic capital markets.
The German MNC will return $52,000,000 and get back 40,000,000 to pay off its
borrowing.
The US MNC will return40,000,000 and get back $52,000,000 to pay off its $
borrowing.
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Net Result
Through currency swap, both MNCs restructure their debts to
mitigate risk and obtain cost-saving:
The U.S. MNC in net borrows euro at an all-in-cost (AIC) of 6%
(vs. 7% it would have to pay in the Eurobond market), with a
cost saving of 1%.
The German MNC in net borrows $ at an all-in-cost (AIC) of 8%
(vs. 9% it would have to pay in the Eurobond market), with a
cost saving of 1%.

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Comments on Currency Swap

Both the principal of the debt and the interest payments are
exchanged.
In fact, currency swap helps exchange one debt for another
(e.g. a $-denominated debt exchanged for a -denominated
debt)
Benefits of using currency swaps
To manage long-term exposure to FX risk.
To obtain a cost saving on borrowing.

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Currency Swap with Bid-Ask Spread

Since the swap bank takes risks by making a market for swaps,
the bid-ask spread will not be zero.
Now assume the swap bank is quoting
5-year $ swaps at 8.00-8.15 percent against $ LIBOR
5-year swaps at 6.00-6.10 percent against $ LIBOR

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Currency Swap Via Swap Bank

Swap
Bank
$8%
6.1%
$8%

U.S.
MNC

$8.15%
6%

German
MNC

6%

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Net Result
The U.S. MNC in net borrows euro at an all-in-cost (AIC) of 6.1%
(vs. 7% it would have to pay in the Eurobond market)
Its cost saving is 0.9% (90bps).
The German MNC in net borrows $ at an all-in-cost (AIC) of 8.15%
(vs. 9% it would have to pay in the Eurobond market)
Its cost saving is 0.85% (85 bps).
Profit earned by the swap bank: 0.25% (25bps)
QSD=1%-(-1%)=2% (200bps), split among the swap bank and two
MNCs.
Remember that a positive QSD is the necessary condition for a
swap to be possible.

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In Depth
Remember that a positive QSD is the necessary condition for a
swap to be possible.
As long as QSD is positive, the swap bank can tailor swaps to
serve all parties' needs.
E.g. suppose that the U.S. MNC is only willing to enter into the
currency swap with a cost saving of 110bps (1.1%).
A curreny swap is still possible since QSD=200bps
The German MNC will gets 85bps.
The U.S. MNC wants to get 110bps.
There are still 5bps left for the swap bank.

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Currency Swap Via Swap Bank

Swap
Bank
$8.20%
6.1%
$8%

U.S.
MNC

$8.15%
6%

German
MNC

6%

In this case, the swap bank pays more than it receives on $-side
of the swap, a compromise it takes to layoff its risk.

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Pricing a Swap Contract

The value of a swap to a counterparty is determined by the
difference between the PV of CFs it will receive and the PV of CFs
it will pay.
The value of a swap contract is zero at initiation.
After the inception of a swap contract, if interest rate or exchange
rate changes, it may become desirable for one and/or the other
counterparty to unwind the swap.

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Pricing the Basic Currency Swap

Assume 1 year after the currency swap was arranged, interest rates and
exchange rate have changed:
Interest rates decreased to $6.75%, and 5%.
The spot rate is S1($/) = $1.310/.
One or both counterparties might have incentives to unwind the swap in order
to refinance at lower rate.
The market value of $ debt is $54,214, 170: PVA($4.16M;4;6.75%)
+PV($52M;4; 6.75%)
The market value of debt is 41,418,380: PVA(2.4M; 4; 5%)+PV( 40 M; 4;
5%)
The U.S. MNC should be willing to pay to unwind the swap (so that it could
refinance $52,000,000 to borrow at 6.75%).
$54, 214, 170 - 41,418,380* $1.310/=-$43,908
The swap has a value of 33,517 to the German MNC:
41,418,380-$54, 214, 170 /$1.310/ = 33,517.
The German MNC should be willing to accept this amount to sell the swap.

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Pricing the Basic Interest Rate Swap

Now assume that 1 year after the inception of the swap, the swap
bank is quoting 4-year dollar interest rate swaps at 9.00-9.125
percent against dollar LIBOR flat.
The market value of the floating rate debt is $10,000,000.
The market value of the 10.5% fixed rate debt is $10,485,958.
PVA($1.05M;4;9%)+PV($10M;4;9%)
The market value of the 10.375% fixed rate debt is $10,445,461.
PVA($1.0375M;4;9%)+PV($10M;4;9%)
Firm B has incentive to unwind the original swap since it pays
10.5% while receiving LIBOR.
B would be willing to pay up to $485, 958 to unwind the original
swap contract.
The value of the swap contract is $445,461 to bank A.

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Development & Growth of the Swap

Market
The development and growth can be explained by market
completeness hypothesis:
Not all types of debt instruments are available to all types of
borrowers.
Swaps allow tailored financing to borrowers and thus offer
market completeness.

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Learning Outcomes
Conduct interest rate/currency swap cash flow analysis
Discuss the motivation of a counterparty to enter into interest
rate/currency swaps
Calculate the all-in cost (AIC) for a swap counterparty
Calculate the profit earned by the swap bank
Price interest rate and currency swaps
Discuss the risks a swap bank encounters in interest rate and
currency swaps

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