1 / 39

Chapter 7 Currency Swaps Swaps Markets

Motivation for a currency swap. A small UK firm wants to convert floating-rate debt into fixed-rate $ debt to offset its revenues from US salesThe UK firm's alternatives includeA direct issue in US dollarsA parallel loan that trades floating-rate debt for the fixed-rate $ debt of a U.S. co

ina
Download Presentation

Chapter 7 Currency Swaps Swaps Markets

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

    1. Chapter 7 Currency Swaps & Swaps Markets

    2. Motivation for a currency swap A small UK firm wants to convert floating-rate Ł debt into fixed-rate $ debt to offset its revenues from US sales The UK firm’s alternatives include A direct issue in US dollars A parallel loan that trades floating-rate Ł debt for the fixed-rate $ debt of a U.S. company

    3. A parallel loan Borrow in your local currency and then trade for the debt of a foreign counterparty Parallel loans provide access to new capital markets Legally circumvent taxes on cross-border currency transactions Provide foreign-source financing for foreign subsidiaries May lower the firm’s cost of capital

    4. Problems with parallel loans The foreign counterparty may have default risk Parallel loans must be capitalized on the balance sheet Search costs can be high

    5. The swap contract The solution: Package the parallel loans into a single legal agreement called the swap contract This reduced the default risk of parallel loans via the rights of set-off Swaps need not be capitalized on the balance sheet As volume in the swaps market rose, search costs were reduced and liquidity increased

    6. Currency swaps… “I’ll pay yours if you pay mine” Currency Swap An agreement to exchange a principal amount of two currencies and, after a pre-arranged length of time, re-exchange the original principal Interest payments are also usually swapped during the life of the contract

    7. Development of the swaps market 1981 Salomon Brothers engineers the first currency swap between the World Bank and IBM Early 1980s Customized, low-volume, high-margin deals Late 1980s and 1990s Commercial and investment banks begin to serve as swaps dealers Swaps turn into a standardized, high-volume, low-margin business Volume and liquidity grow

    8. A note on day count conventions Adjusting for day count conventions Bond equivalent yields (BEY) are quoted as Actual/365 Money market yields (MMY) are quoted as Actual/360 The relation between the two is MMY = BEY (360/365)

    9. Example of a currency coupon swap Ford Motor Company (U.S.) Ford has $100 million in 2-year, fixed-rate dollar debt at 6.62% compounded semiannually (sa) Ford wants floating-rate Indian rupee debt Tata Motors (India) TM has Rupee 4.032 billion in 2-year, floating-rate rupee debt with semiannual payments priced at LIBOR+60 bps TM wants fixed-rate U.S. dollar debt

    10. Pricing schedule for a Rupee/$ currency coupon swap Maturity Bid ($) Ask ($) 2 years 6.04% 6.20% All quotes are U.S. dollars semiannual actual/365 against 6-month LIBOR flat in rupees S0Rp/$ = Rp 40.3200/$ Assume yield curves are flat, and the dollar is selling at a six-month forward premium of 2.04%

    11. TM’s “uncovered” swap cash flows

    12. TM’s “fully covered” swap cash flows

    13. A “fully covered” swap (floating-to-fixed conversion) 1. Convert the floating rate (MMY) spread to LIBOR into BEY = MMY (365/360) 2. Find the corresponding spread in the other currency from equation (7.2) (7.2) 3. Calculate the fixed rate payment from the spread and the swap ask rate

    14. 1. Convert the floating rate (MMY) spread to LIBOR into BEY TM’s 30 bp spread to LIBOR is quoted as a money market yield (MMY) The bond equivalent yield is BEY = MMY (365/360) = (30 bps) (365/360) = 30.4167 bps every six months or 60.8333 bps per year (sa)

    15. 2. Find the corresponding spread in the other currency The $ swap mid-rate is 6.12 percent or i$ = 3.06 percent per six months The dollar is at a 6-month forward premium of 2.04%, so the 6-month rupee interest rate is iRp = (1+i$)(F1Rp/$/S0Rp/$)–1 = (1.0306)(1.0204)–1 = 5.162424% per six months

    16. 2. Find the corresponding spread in the other currency Equation (7.2) is used to find an equivalent fixed rate spread in another currency (7.2) Yield curves are flat in our problem, so the following values are useful: PVIFA$ (3.060000%, 4 periods) = 3.711771 PVIFARp (5.162424%, 4 periods) = 3.532613

    17. 2. Find the corresponding spread in the other currency TM’s LIBOR spread is 30.4167 bps in rupees Solving equation (7.2) for the equivalent dollar spread r$ results in (7.2) or r$ = (30.4167 bps) (3.532613 / 3.711771) = 28.9485 bps per six months

    18. 3. Calculate the payment from the swap ask rate and the spread TM’s all-in cost of fixed rate dollar debt is 3.100000 percent (swap ask rate) + 0.289485 percent (spread) r$ = 3.389485 percent per six months or 6.778970 percent per year compounded semi-annually or APR = (1.03389485)2 – 1 = 6.893857%

    19. Ford’s “uncovered” swap cash flows

    20. Ford’s “fully covered” swap cash flows

    21. A “fully covered” swap (fixed-to-floating conversion) 1. Find the spread over the swap bid rate 2. Find the corresponding spread in the other currency from equation (7.2) (7.2) 3. Convert this BEY spread to a MMY spread over LIBOR

    22. 1. Calculate the spread to the swap bid rate Ford’s dollar spread to the swap bid rate is 3.31 percent (fixed interest rate) – 3.02 percent (swap bid rate) r$ = 0.29 percent every six months ($)

    23. 2. Find the corresponding premium in the other currency Solving equation (7.2) for the rupee spread rRp that yields the same present value as the dollar spread results in (7.2) or rRp = (29 bps) (3.711771 / 3.532613 ) = 30.4708 bps per six months (BEY)

    24. 3. Convert the BEY spread to a floating rate MMY spread Ford’s 30.4708 bp spread is quoted as a bond equivalent yield (BEY) The corresponding money market yield is MMY = BEY (360/365) = (30.4708 bps) (360/365) = 30.0533 bps every six months Ford’s all-in cost of floating rate rupee debt is LIBOR + 60.1067 bps (sa)

    25. The swap bank’s “uncovered” cash flows

    26. The swap bank’s “fully covered” cash flows

    27. The swap bank’s “fully covered” cash flows

    28. Interest rate swaps Interest rate swap Same as a currency swap, but in a single currency A difference check is paid during the life of the swap The principal is purely notional, and is not swapped

    29. Floating-to-fixed conversion for an interest rate swap 1. Convert the floating rate (MMY) spread to LIBOR into BEY = MMY (365/360) 2. Find the corresponding spread in the other currency from equation (7.2) Step 2 is no longer necessary… 3. Calculate the fixed rate payment from the spread and the swap ask rate

    30. Fixed-to-floating conversion for an interest rate swap 1. Find the spread over the swap bid rate 2. Find the corresponding spread in the other currency from equation (7.2) Step 2 is no longer necessary… 3. Convert this BEY spread to a MMY spread over LIBOR

    31. Commodity swaps Commodity swaps are traded against a variety of commodity prices including Oil Gold Pork belly prices Most commodity swaps are fixed-for-floating swaps based upon spot prices

    32. An oil-for-euro swap A Dutch chemicals manufacturer uses 500,000 barrels of oil every 3 months The manufacturer has contracted to sell its products at a fixed euro price for 5 years and wants to fix its input costs in euros as well

    33. An oil price swap

    34. An oil price swap

    35. An oil price swap

    36. A debt-for-equity swap A London bank holds a volatile portfolio of H-shares that is highly correlated with the Hang Seng China Enterprises index The bank decides it would rather hold fixed-rate pound sterling debt Combine the following three swaps to achieve the desired result: A fixed-for-floating Ł interest rate swap A pound-for-HK$ currency swap An equity swap for fixed-rate HK$ debt

    37. Swapping H-shares for Ł debt

    38. Swapping H-shares for Ł debt

    39. Swapping H-shares for Ł debt

    40. Swaptions A swaption is a swap with one or more options attached Interest rate ceilings or floors Exchange rate caps Multiple options (e.g. cylinder options) The option component of a swaption is on the underlying fixed-rate bond and is priced accordingly

More Related