Currency and Interest Rate Swaps - Stanford Universityweb.stanford.edu/class/msande247s/2008/sixth...

http://Stanford2008.pageout.net

Handout #16 as of 0722 2008

Derivative Security MarketsCurrency and Interest Rate Swaps

MWF 3:15-4:30 Gates B01Final Exam MS&E 247S

Fri Aug 15 2008 12:15PM-3:15PM Gates B01Or Saturday Aug 16 2008 12:15PM-3:15PM Gates B01

Remote SCPD participants will also take the exam on Friday, 8/15Please Submit Exam Proctor’s Name, Contact info as SCPD requires, also c.c. to

[email protected], preferably a week before the exam.Local SCPD students please come to Stanford to take the exam. Light

refreshments will be served.

13-2

Levich

Luenberger

Solnik

McDonald

Chap 13

Chap

Chap

Chap

Scan Read

Pages

Pages

Pages

Pages

Ch 8 Swaps Pages 219-246

Currency and Interest Rate Swaps

Wooldridge

Reading Assignments for this Week

Fundamentals of Derivative Markets

Derivative Security MarketsCurrency and Interest Rate Swaps

MS&E 247S International InvestmentsYee-Tien Fu

13-4

Medical Swap vs. Financial Swaphttp://www.pageout.net/user/www/s/t/stanford2007/medical%20swap.pdf

13-5

• 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.

• In the case of a currency swap, there is an initial exchange of currency and a reverse exchange at maturity.

Introduction to Swaps

13-6

• 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.


13-7

• 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.


13-8

• 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-of-offset 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.


13-9

• We will focus primarily on the economic fundamentals and financial characteristics of basic interest rate and currency swap agreements.


13-10

Structure of a Back-to-Back on Parallel LoanBasic Swap

Dutch firm’saffiliate in the

United Kingdom

British firm’saffiliate in theNetherlands

Britishparent firm

Dutchparent firm

In the United Kingdom In the Netherlands

Direct loanin guilders

Direct loanin pounds

Indirectfinancing

Figure 13.1 Pg 448

13-11

• 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 incentive to the French firm to take part in the deal.

The Role of Capital Controls

13-12

Structure of a Back-to-Back on Parallel LoanVariation

U.S.parent firm

U.S. firm’saffiliate in Brazil

French firm’saffiliate in Brazil

Frenchparent firm

In the United States In Brazil

Direct loanin cruzados

Direct loanin dollars

Indirectfinancing

Figure 13.1 Pg 448

13-13

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.

3 For accounting and regulatory purposes, the loans are “loans”. Thus, the firm’s borrowing capacity, credit rating etc can be affected.

The Role of Capital Controls

13-14

• The currency swap evolved as a way to simplify and speed the exchange of currency cash flows between counterparties.

• In addition, it linked the two cash flows :¤ Only the net difference between the two cash

flows is paid.¤ 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.

Factors Favoring the Risk of Swaps

13-15

The Swap Market• The notional value of outstanding swaps is

the underlying amount on which swap payments are based.

• A more meaningful indicator of the economic significance of outstanding swaps is the gross market value, which reflects the cost that one party would pay to replace a swap at market prices in the event of a default.

• Gross market value represents the gross exposure associated with swap contracts.

13-16

The Basic Cash Flows of a Currency Swap

• Firm A has a comparative advantage in borrowing US$ while firm B has a comparative advantage in borrowing SFr.

• By borrowing in their comparative advantage currencies and then swapping, lower cost financing is possible.

11.5%10%

5% 6%

Firm A Firm B

US$finance

SFrfinance

Difference(A-B)

-1.5%

-1.0%

-0.5%

• Firms A and B can each issue a 7-year bond in either the US$ or SFr market.

Figure 13.2 Pg 453

13-17

• Together, A and B save 0.5%. Note that if a bank or swap dealer intermediates the transaction and charges a fee, the aggregate interest savings will be reduced.

The Basic Cash Flows of a Currency Swap

A B10.75% (US$)

5.5% (SFr)

$ at t7SFr at t7

$ at t0SFr at t0

Borrows $at 10%

Borrows SFrat 6%

Figure 13.2 Pg 453

13-18

The Basic Cash Flows of a Currency Swap: Result of Strategy

Firm A pays 5.5% (to B) on its SFr150 million loan. But firm A also pays 10.0% interest on its US$ bonds while receiving 10.75% interest on its US$100 million loan to B -- or a net inflow of 0.75%. Thus, A pays (approximately) 4.75% net interest on its SFr loan. This represents a 0.25% savings in relation to its own cost of borrowing SFr. Note that the calculation is approximate because 1% interest on US$ is not precisely the same as 1% interest on SFr.

13-19

The Basic Cash Flows of a Currency Swap: Result of Strategy

Firm B pays 10.75% (to A) on its US$100 million loan. But B also pays 6.0% interest on its SFr bonds and receives 5.5% interest on its SFr 150 million loan to A -- or a net outflow of 0.5%. Thus, B pays (approximately) 11.25% net interest on its US$ loan. This represents a 0.25% savings in relation to its own cost of borrowing US$. Note that the calculation is approximate because 1% interest on US$ is not precisely the same as 1% interest on SFr.

13-20

A Summary of the IBM / World Bank Currency Swap

• The World Bank had an absolute advantage in the US$ market, while IBM had an absolute advantage in the SFr bond market.

• Examining these borrowing costs, we see that the firms could save 25bp by entering into a currency swap.

• IBM and the World Bank can each issue a 7-year bond in either the US$ or SFr market.

Box 13.1 Pg 455

U.S.Treasury+ 45 bp

IBMWorldBank

$finance

SFrfinance

Difference

5bp

- 20bp

25bp

U.S.Treasury+ 40 bp

SwissTreasury+ 0 bp

SwissTreasury+ 20 bp

13-21

• 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.

World Bank IBM

U.S. Treas.+40

Swiss Treas.+10

$ at t7SFr at t7

$ at t0SFr at t0

Borrows $at U.S.

Treasury + 40

Borrows SFrat Swiss

Treasury + 0

A Summary of the IBM / World Bank Currency Swap

Box 13.1 Pg 455

13-22

Saturation and scarcity valueIn 1981, both IBM and the World Bank were rated AAA for credit risk. But in the real world, all AAA credits are not necessarily awarded the same interest cost of funds, even if the bond issues share similar 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.

13-23

Saturation and scarcity value

Until 1981, the World Bank was a frequent issuer of bonds in the Swiss market in order to capture the low nominal interest rate in SFr.With the demand for World Bank bonds saturated at prevailing rates, Swiss investors demanded a higher interest rate to hold additional World Bank bonds. IBM, on the other hand, viewed themselves as a US$-based firm and borrowed exclusively in the US$ bond markets.Swiss investors were willing to pay a premium (reflecting a scarcity value) to bring IBM as a new AAA-issuer into their portfolios.

13-24

Interest Rate SwapIn 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.This example assumes that interest is paid semiannually and the floating interest rate is reset every six months.

13-25

The Basic Cash Flows of an Interest Rate Swap

A B9.75%

LIBOR + .25

Borrows at9.0% fixed

Borrows atLIBOR + 0.50%

floating

10.5%9%

LIBOR+0.0%

LIBOR+0.5%

Firm A Firm BFixed-rate

financeFloating-

ratefinance

Difference(A-B)

-1.5%

-0.5%

-1.0%

Figure 13.3 Pg 456

13-26


To explain the transactions in an interest rate swap, assume that in period t0, firm A issues a seven-year bond for $100 million at a fixed rate of 9% and B obtains bank financing for $100 million at a floating rate equal to six-month LIBOR + 0.5%. In our example, the principal amounts are identical, so there is no need to actually exchange principal as in the currency swap example. However (and as if there were an exchange of principal), A agrees to pay LIBOR + 0.25% interest on $100 million to B, while B agrees to pay 9.75% interest on $100 million to A.

13-27


In years t1 until t7, firms A and B make interest payments to each other as stipulated in the swap agreement, plus paying interest on the original bonds they have issued.

At time t7, the swap contract matures. A and B make their final interest payments to each other, A retires its outstanding bond issue, and B pays off its bank loan.

13-28


What is the result of this strategy? Firm A pays LIBOR + 0.25% interest (to B) and 9.0% on its fixed-rate bonds, while receiving 9.75% interest from B -- or a net interest cost of LIBOR - 0.50%.Thus, A saves 0.50% in relation to its own cost of floating-rate funds.

13-29

Profit and Loss from Entering into an Interest Rate Swap When Interest Rates Are Variable

Speculativeposition

Pay floatingand receivefixed

Pay fixedand receivefloating

Speculative loss, swap has negative value, out-of-the-money swap

Speculative gain, swap has position value, in-the-money swap

Speculative gain, swap has position value, in-the-money swap

Speculative loss, swap has negative value, out-of-the-money swap

Interest Rates Rise Relative to

Expectations

Interest RatesFall Relative to Expectations

Behavior of Floating Interest Rates

Table 13.4 Pg 464

13-30

Behavior of Short-Term Interest Ratesand the Valuation of Fixed Floating Swap

Valuation Effects for Paying Fixed and Receiving Floating

i5,5 = 5.42

Period 1 Period 2 Period 3 Period 4 Period 5

i5,4 = 5.32

i5,3 = 5.22

i5,2 = 5.12

i5,1 = 5.02

Initial Euro-$Interest Rate

i1 = 5.22Positive value, In the money

Negative value, Out of the money

Figure 13.5 Pg 465

13-31

The Amortization Effect and the Diffusion Effectin a Long-Term Interest Rate Swap

Pote

ntia

l Exp

osur

e (%

)

Time

AmortizationEffect

DiffusionEffect

Figure 13.6A Pg 466

13-32

The Overall Risk in a Long-TermInterest Rate Swap

Pote

ntia

l Exp

osur

e (%

)

Time

Interaction ofAmortizationand Diffusion

Effect

Figure 13.6B Pg 466

13-33

Expected Credit Exposures on Interest Rate Swaps: The Maturity Effect

Perc

ent o

f Not

iona

l Prin

cipa

l

Semiannual Periods4 8 12 16 200

2

4

6

8

10

1-year3-year

5-year7-year

10-year

Figure 13.7A Pg 467

13-34

Expected Credit Exposures on 10-YearInterest Rate Swaps: The Interest Rate Level Effect

Perc

ent o

f Not

iona

l Prin

cipa

l

Semiannual Periods4 8 12 16 200

2

4

6

8

10

13%

7%

9%

11%

Figure 13.7B Pg 468

13-35

Swaps & Linkages Across International Capital Markets

InterestRate Swap

CrossCurrency

InterestRate Swap

CrossCurrency

Interest Rate Swap

Interest Rate Swap Floating-Floating Currency Sw

apFixe

d-Fi

xed

Cur

renc

y Sw

ap

A B

C D

Cur

renc

y X

Cur

renc

y Y

Fixed RateAsset or Liability

Floating RateAsset or Liability

Interest Rate Base

Currency ofDenomination

Figure 13.8 Pg 469

ExamplesA Dollar-denominated

straight EurobondB Eurodollar floating-

rate note (FRN)C Samurai bondD Euroyen floating-

rate note (FRN)

13-36

An Example of Price Quotations in the Swap Market

Table 13.5 presents a sample of swap quotations from a major dealer.Various interest rate swap quotations within the US$ segment are shown in panel A of Table 13.5.Various cross-currency interest rate swap quotations for the US$ against other currencies are shown in panel B of Table 13.5.A diagram illustrating how the quotation apply to the dealer and the counterparties is in panel C.

13-37


Table 13.5 Pg 470

Panel A: U.S. Dollar Interest Rate Swaps

Maturity Treasury Yield Treasury vs. LIBOR2 5.94 Bid Offer

18 20

Treasury vs. T-Bills Treasury vs. CPBid Offer Bid Offer-21 -16 12 16

Note: Quotes are in basis points over/under Treasury bond yield.

13-38


Table 13.5 Pg 470

Panel B: Non-U.S. Dollar Interest Rate Swaps

Maturity Japanese Yen Pound Sterling2 Bid Offer Bid Offer

1.49 1.53 6.507 6.557

Deutsche Mark Swiss FrancBid Offer Bid Offer4.035 4.085 2.990 3.090

Note: Quotes are on an actual/365 day semi-annual basis.

13-39

Price Quoting Conventions in the Swap Market

CounterParty A

SwapDealer

CounterParty B

Swap dealer receives

floating rate

Swap dealer pays fixed

rate

Swap dealer pays

floating rate

Swap dealer receives fixed rate

Bid Quote Offer QuoteSwap Quotes

Quotes are given from the perspective of the swap dealer.The convention is to quote only the fixed side of the swap.All fixed quotes are against LIBOR unless otherwise stated.

Panel C of Table 13.5 Pg 470

13-40

Constructing a Fixed-Fixed Currency Swap

Suppose a US firm (A) issues a seven-year Euro-Y straight bond with a coupon of 3.80%, and that a Japanese firm (B) issues a seven-year Euro-$ straight bond with a coupon of 7.40%. Assume that A wishes to obtain fixed-rate US$ financing and that B wishes to obtain fixed-rate Y financing and that both are willing to trade at the quotes in Table 13.5 from the swap dealer at Merrill Lynch. 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.

13-41

Construction of a Fixed-Fixed Currency Swap

Borrowsfixed-rate¥ bond at

3.80%

MerrillLynch

JapaneseFirm B

LIBOR ($)LIBOR ($)

U.S.Firm A

LIBOR ($)LIBOR ($)

6.65%($)6.67%($)

3.14%(¥)3.10%(¥)

Borrowsfixed-rate$ bond at

7.40%

Table 13.6 Pg 472

13-42


To convert its fixed-rate Euro-Y bond into a fixed-rate US$ liability, firm A enters into two swaps with Merrill Lynch:

1. A cross-currency swap paying $-LIBOR and receiving 3.10% in Y.

2. An interest rate swap paying 6.67% in $ (equal to 6.32% T-bond rate + 0.35%) and receiving $-LIBOR.

We can see that the two LIBOR portions cancel, leaving firm A with a fixed-rate US$ liability costing 7.37%.

13-43


Firm B also enters into two swaps with Merrill Lynch:

1. A cross-currency swap receiving $-LIBOR and paying 3.14% in Y.

2. An interest rate swap receiving 6.65% in $ (equal to 6.32% T-bond rate + 0.33%) and paying $-LIBOR.

Again, we can see that the two LIBOR portions cancel, leaving firm B with a fixed-rate Y liability costing 3.89%.

13-44


As the intermediary in this transaction, Merrill Lynch earns 0.04% in Y and another 0.02% in US$ on a per annum basis over the seven-year life of the swap.

In addition, Merrill Lynch receives a fee for originating each swap.

All of these transactions are summarized in Table 13.6.

13-45

Applications of Swaps: Magnifying Risk and Return

Many of the illustrations in this chapter have linked a swap with a bond issue, but these decisions are separable.

A firm can issue a bond in one year and then decide to swap later, using the swap as a risk management tool.

However, a firm could enter into a swap without a prior bond issue. This transaction is the same as a pure speculation on the direction of exchange rates or interest rates.

13-46

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.

13-47

An Unsuccessful Exotic Swap

Procter and Gamble (P&G) (based in Cincinnati and with $30 billion in annual sales) lost $157 million on an exotic swap whose payments (“in most cases”) were defined by the formula:

17.0415 x (5-year Treasury rate) - (price of 6.25 percent Treasury due 8/2023)- 0.75%

The amount of interest that P&G would pay under this formula is shown in Table 13.7.

13-48

30-Year Interest Rate5-year Int 6% 7% 8%

5% -0.75% -0.75% 4.20%6% -0.75% 10.80% 21.20%7% 15.10% 24.90% 38.20%

Table 13.7 Interest Cost (Premium over the CP Rate)in the Procter & Gamble/Bankers Trust Interest Rate Swap

13-49

An Unsuccessful Exotic SwapThis arrangement would have reduced P&G’s funding costs below the commercial paper rate if short-term interest rates fell. But if interest rates rose, P&G was subject to enormous borrowing costs on its $200 million notional value.P&G closed its swap position to cap their loss, and filed suit against the swap dealer (Bankers Trust), alleging that the dealer failed to make sufficient disclosures of the risks involved in the transaction. Bankers Trust claimed that it had acted in good faith and that it was dealing with a sophisticated investor with extensive experience in exotic derivatives.

13-50

P&G added a second money-losing DM interest rate swap to its lawsuit, bringing its total claim against Bankers Trust to $200 million.

P&G and Bankers Trust settled their dispute in May 1996, after Bankers Trust agreed to absorb at least $150 million of P&G’s loss.

Around this time, it was reported that some banks had chosen to absorb losses on swap transactions, rather than risk bad publicity or litigation.

An Unsuccessful Exotic Swap

13-51

Assignment from Chapter 13Exercises 1, 2.

13-52

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 7-year bonds at the fixed rate of 10% in the US in US$ and at 14% in France in FFr.

a. Which firm has a comparative advantage in the French capital market?

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. How much could be saved in borrowing costs by both firms?

d. What could cause the relative comparative advantages in international credit markets?

13-53

SOLUTION:

a. ABC XYZ DifferenceUS$ 8% 10% -2%FFr 13% 14% -1%

-1%XYZ has a comparative advantage in the French franc market; ABC has a comparative advantage in the US$ market.

b. Each firm has a comparative advantage in different markets. They should take advantage of that edge, then swap the proceeds, thusrealizing borrowing cost savings.

13-54

c. Total Costs:ABC Pays 8.0% XYZ Pays 14.0%

Pays 13.5% Pays 9.0%Receives 9.0% Receives 13.5%Net 12.5% Net 9.5%

Savings .5% Savings .5%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.

Different valuation on the same credit instrument could also arise because the French and US credit markets make different assessments of the riskiness of the same firms.

13-55

2. Suppose two parties enter a 5-year interest rate swap to exchange one-year LIBOR plus 50 basis points (bp) for a fixed rate on $100 million notional principal.

a. If LIBOR turns out to be 10% in year 1, 9% in year 2, 9% in year 3, 8% in year 4 and 8.5% in year 5, what cash flows will beexchanged between the two parties? Assume a flat Eurodollar yield curve at 10%.

b. What is the value of the swap?

c. What fixed rate in the swap agreement will make the value of the swap equal to zero?

13-56

SOLUTIONS:a. The cash-flow pattern is as follows:

1 2 3 4 5Fixed 10% 10% 10% 10% 10%Cash-Flows 10 10 10 10 10LIBOR +50 bp 10.5% 9.5% 9.5% 8% 8.5%Cash-Flows 10.5 9.5 9.5 8 8.5Difference -.5 .5 .5 2 1.5

b. The NPV at 10% yields a positive value of $2.63 for the fixed-rate payer.

c. A fixed-rate of approximately 9.375% will make the NPV equal to zero.

Currency and Interest Rate Swaps - Stanford Universityweb.stanford.edu/class/msande247s/2008/sixth...

Documents

Transcript of Currency and Interest Rate Swaps - Stanford Universityweb.stanford.edu/class/msande247s/2008/sixth...