SWAPs

Interest Rate and Currency Swaps

Swap
Swap

is an agreement between two companies to exchange cash flows in future. The agreement defines the dates, when the cash flows are to be paid and the way in which they are to be calculated.

Mechanism of Interest rate Swap

Plain

vanilla interest rate swap Company agree to pay cash flows equal to interest at predetermined fixed rate on a notional principal for a number of years In return, it receives interest at a floating rate on the same notional principal for the same period of time. Floating rate in most agreement is LIBOR

Illustration
3 year swap initiated on march 5, 2009 between Microsoft and Intel. Microsoft agrees to pay Intel an interest rate of 5 % p.a. on principal of 100 million. In return, Intel agrees to pay Microsoft the 6 months LIBOR rate on same principal. Microsoft fixed rate payer Intel- Floating rate payer. Also assume agreement specifies that payments are to be exchanged every 6 months and 5 % interest rate is quoted with semi annual compounding

Illustration
First

exchange take place on Sept. 5 2009 Microsoft pay Intel $2.5 mn.(100*0.5*.05) Intel pay Microsoft 6 month LIBOR prevailing 6 month prior to 05/09/2009. Let LIBOR on 5/03/2009 is 4.2% Intel pays Microsoft $2.1 mn(100*.5*.042)

Cash flow to Microsoft

Date
5/3/2009

6 M LIBOR
4.2

Floating cash flows received

Fixed cash flows paid

Net Cash flow

5/9/2009
5/3/2010 5/9/2010 5/3/2011 5/9/2011 5/3/2012

4.8
5.3 5.5 5.6 5.9

2.1
2.4 2.65 2.75 2.8 2.95

-2.5
-2.5 -2.5 -2.5 -2.5 -2.5

-0.4
-0.1 0.15 0.25 0.3 0.45

Cash flow to Intel

Date 5/3/2009 5/9/2009 5/3/2010 5/9/2010 5/3/2011 5/9/2011 5/3/2012 6 M Floating cash Fixed cash LIBOR flows paid flows Received 4.2 4.8 5.3 5.5 5.6 5.9 -2.1 -2.4 -2.65 -2.75 -2.8 -2.95 2.5 2.5 2.5 2.5 2.5 2.5 0.4 0.1 -0.15 -0.25 -0.3 -0.45 Net Cash flow

Diagrammatic Representation
5%

Intel
LIBOR

Microsoft

Microsoft Long floating rate Bond Short Fixed rate bond Intel-Long Fixed rate bond and short floating rate Bond

Using SWAP to transform Liability

5.2 % LIBOR

Intel

5%

Microsoft

LIBOR+0.1%

Microsoft

borrow 100 mn @ LIBOR+0.1% Want to convert floating rate loan to fixed rate loan Use swap to convert liability

 Cash

Using SWAP to transform Liability

flows for Microsoft

Pay LIBOR + 0.1% to its outside lender Pay 5% under the term of swap Receives LIBOR under the term of swap
Net

cash flow of 5.1% to Microsoft Cash flows for Intel

Pay 5.2% to its outside lender Pay LIBOR under the term of swap Receives 5% under the term of swap Net cash flow of LIBOR + 0.2%

Using SWAP to transform Asset

LIBOR-0.2% LIBOR 4.7 %

Intel

5%

Microsoft

Microsoft

Owns bond worth 100 mn @ 4.7% Want to convert fixed rate bond to floating rate bond Use swap to convert asset

Using SWAP to transform Asset

Cash

flows for Microsoft

Receives 4.7 % on the bond Receives LIBOR under the term of swap Pays 5% under the term of swap
Net

cash flow of LIBOR -0.3% to Microsoft Cash flows for Intel

Receives LIBOR-0.2 % on its investment Pay LIBOR under the term of swap Receives 5% under the term of swap Net cash flow of 4.8%

Role of Intermediary
Non

financial companies dont have contact Take help of Financial intermediaries like bank, swap dealers etc Charge fees for intermediate
4.985 % 5.2 % 5.015% LIBOR+0.1 %

Intel
LIBOR

Intel

Microsoft
LIBOR

Comparative Advantage

Interest rate swaps can be used to exploit differentials in the credit market Firm A and Firm B currently face the following borrowing possibilities:
Firm A B Quality Spread Fixed Rate Current 5-yr T-bond + 25 bp Current 5-yr T-bond + 85 bp 60 bp Floating Rate LIBOR LIBOR + 30 bp 30 bp

Exploiting Comparative Advantage

Firm A has an absolute advantage over B in both the fixed and the floating rate markets. A has a comparative advantage in the fixed rate market. The total gain available to be shared among the swap participants is the differential in the fixed rate market minus the differential in the variable rate market, or 30 bps.

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Exploiting Comparative Advantage

Firm A wants to issue a floating rate bond, while Firm B wants to borrow at a fixed rate. Both banks will borrow at a lower cost if they agree to an interest rate swap. Firm A should issue a fixed rate bond because it has a comparative advantage in this market. Firm B should borrow at a floating rate. The swap terms split the rate savings 50-50. The current 5-yr T-bond rate is 4.50%.

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Exploiting Comparative Advantage

A
Treasury + 25 bp LIBOR Treasury + 40 bp LIBOR +30 bp

Bondholders

Bondholders
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Exploiting Comparative Advantage in the Credit Market

The net borrowing rate for Firm A is LIBOR 15 bps The net borrowing rate for Firm B is Treasury + 70 bps The net rate for both parties is 15 bps less than without the swap.
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Foreign Currency Swaps

In

a currency swap, two parties

Exchange currencies at the prevailing exchange rate Then make periodic interest payments to each other based on a predetermined pair of interest rates, and Re-exchange the original currencies at the conclusion of the swap
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Foreign Currency Swaps (contd)

Cash

flows at origination:
FX Principal

Party 1

US $ Principal

Party 2

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Foreign Currency Swaps (contd)

Cash

flows at each settlement:

$ LIBOR

Party 1

FX Fixed Rate

Party 2

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Foreign Currency Swaps (contd)

Cash

flows at maturity:
US $ Principal

Party 1

FX Principal

Party 2

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Foreign Currency Swaps (contd)

Foreign Currency Swap Example
A

multinational US corporation has a subsidiary in Germany. It just signed a 3-year contract with a German firm. The German firm will provide raw materials, with the US firm paying 1 million Euros every 6 months for the 3-year period. The current exchange rate is $0.90/Euro. The contract is fixed in Euro terms, but if the dollar depreciates against the Euro, dollar accounts payable would increase.
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Foreign Currency Swaps (contd)

Foreign Currency Swap Example (contd)
A currency swap is possible with the following terms: Tenor = 3 years Notional value = 25 million Euros ($22.5 million) Floating rate = $ LIBOR Fixed rate = 8.00% on Euros
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Foreign Currency Swaps (contd)

Foreign Currency Swap Example (contd)
The swap will result in the following payments

every six months: Fixed rate payment = 25,000,000 Euros x 8.00% x 0.5 = 1,000,000 Euros Floating rate payment = $22.5 million x 0.5 x LIBOR
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Foreign Currency Swaps (contd)

Foreign Currency Swap Example (contd) Cash Flows at Origination
25 million euros
Party 1 Party 2

$22.5 million

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Foreign Currency Swaps (contd)

Foreign Currency Swap Example (contd) Cash Flows at Each Settlement
$ LIBOR

Party 1
1 million euros

Party 2

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Foreign Currency Swaps (contd)

Foreign Currency Swap Example (contd) Cash Flows at Maturity
$22.5 million

Party 1
25 million euros

Party 2

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Thank You