Prepared by Shafiq Jadallah

1. Chapter 14 Interest Rate & Currency Swaps Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

2. Chapter 14Interest Rate & Currency Swaps • Learning Objectives • Define interest rate risk and demonstrate how it can be managed • Describe interest rate swaps and show how they can be used to manage interest rate risk • Show how interest rate swaps and cross-currency swaps can be used to manage both foreign exchange and interest rate risk simultaneously

3. Interest Rate Risk • All firms, domestic or multinational, are sensitive to interest rate movements • The single largest interest rate risk of a non-financial firm is debt service • For an MNE, differing currencies have differing interest rates thus making this risk a larger concern • The second most prevalent source of interest rate risk is its holding of interest sensitive securities • Ever increasing competition has forced financial managers to better manage both sides of the balance sheet

4. Interest Rate Risk • Whether it is on the left or right hand side, the reference rate of interest calculation merits special attention • The reference rate is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation • Most common is LIBOR (London Interbank Offered Rate)

5. Management of Interest Rate Risk • The management dilemma is the balance between risk and return • Since most treasuries do not act as profit centers, their management practices are typically conservative • Before treasury can take any hedging strategy, it must first form an expectation or a directional and/or volatility view • Once management has formed its expectations about future interest rate levels and movements, it must then choose the appropriate implementation of a strategy

6. Credit and Repricing Risk • Credit Risk or roll-overrisk is the possibility that a borrower’s creditworthiness at the time of renewing a credit, is reclassified by the lender • This can result in higher borrowing rates, fees, or even denial • Repricing riskis the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is being reset

7. Credit and Repricing Risk • Example: Consider a firm facing three debt strategies • Strategy #1: Borrow $1 million for 3 years at a fixed rate • Strategy #2: Borrow $1 million for 3 years at a floating rate, LIBOR + 2% to be reset annually • Strategy #3: Borrow $1 million for 1 year at a fixed rate, then renew the credit annually • Although the lowest cost of funds is always a major criteria, it is not the only one

8. Credit and Repricing Risk • Strategy #1 assures itself of funding at a known rate for the three years; what is sacrificed is the ability to enjoy a lower interest rate should rates fall over the time period • Strategy #2 offers what #1 didn’t, flexibility (repricing risk). It too assures funding for the three years but offers repricing risk when LIBOR changes • Strategy #3 offers more flexibility and more risk; in the second year the firm faces repricing and credit risk, thus the funds are not guaranteed for the three years and neither is the price

9. Trident’s Floating-Rate Loans • Example using Trident corporation’s loan of US$10 million serviced with annual payments and the principal paid at the end of the third year • The loan is priced at US dollar LIBOR + 1.50%; LIBOR is reset every year • When the loan is drawn down initially (at time 0), an up-front fee of 1.50% is charged • Trident will not know the actual interest cost until the loan has been completely repaid

10. Trident’s Floating-Rate Loans

11. Trident’s Floating-Rate Loans • If Trident had wished to manage the interest rate risk associated with the loan, it would have a number of alternatives • Refinancing – Trident could go back to the lender and refinance the entire agreement • Forward Rate Agreements (FRAs) – Trident could lock in the future interest rate payment in much the same way that exchange rates are locked in with forward contracts • Interest Rate Futures • Interest Rate Swaps – Trident could swap the floating rate note for a fixed rate note with a swap dealer

12. Forward Rate Agreements (FRAs) • A forward rate agreement is an interbank-traded contract to buy or sell interest rate payments on a notional principal • Example: If Trident wished to lock in the first payment it would buy an FRA which locks in a total interest payment at 6.50% • If LIBOR rises above 5.00%, then Trident would receive a cash payment from the FRA seller reducing their LIBOR payment to 5.0% • If LIBOR falls below 5.00% then Trident would pay the FRA seller a cash amount increasing their LIBOR payment to 5.00%

13. Interest Rate Futures • Interest Rate futures are widely used; their popularity stems from high liquidity of interest rate futures markets, simplicity in use, and the rather standardized interest rate exposures firms posses • Traded on an exchange; two most common are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) • The yield is calculated from the settlement price • Example: March ’03 contract with settlement price of 94.76 gives an annual yield of 5.24% (100 – 94.76)

14. Interest Rate Futures • If Trident wanted to hedge a floating rate payment due in March ’03 it would sell a futures contract, or short the contract • If interest rates rise, the futures price will fall and Trident can offset its interest payment with the proceeds from the sale of the futures contracts • If interest rates rise, the futures price will rise and the savings from the interest payment due will offset the losses from the sale of the futures contracts

15. Exposure or Position Futures Action Interest Rates Position Outcome Sell a futures (short) Buy a futures (long) Paying interest on futures date Earning interest on futures date If rates go up If rates go up Futures price falls; Short earns profit Futures price falls; Long earns a loss If rates go down If rates go down Futures price rises; short earns a loss Futures price rises; Long earns profit Strategies Using Interest Rate Futures

16. Interest Rate Swaps • Swaps are contractual agreements to exchange or swap a series of cash flows • If the agreement is for one party to swap its fixed interest payment for a floating rate payment, its is termed an interest rate swap • If the agreement is to swap currencies of debt service it is termed a currency swap • A single swap may combine elements of both interest rate and currency swap • The swap itself is not a source of capital but an alteration of the cash flows associated with payment

17. Interest Rate Swaps • If firm thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating in order to protect it from rising debt-service payments • If firm thought that rates would fall it would enter into a swap agreement to pay floating and receive fixed in order to take advantage of lower debt-service payments • The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments

18. Trident Corporation:Swapping to Fixed Rates • Maria Gonzalez (Trident’s CFO) is concerned about the floating rate loan • Maria thinks that rates will rise over the life of the loan and wants to protect Trident from an increased interest payment • Maria believes that an interest rate swap to pay fixed/receive floating would be Trident’s best alternative • Maria contacts the bank and receives a quote of 5.75% against LIBOR; this means that Trident will receive LIBOR and pay out 5.75% for the three years

19. Trident Corporation:Swapping to Fixed Rates • The swap does not replace the original loan, Trident must still make its payments at the original rates; the swap only supplements the loan payments • Trident’s 1.50% fixed rate above LIBOR must still be paid along with the 5.75% as per the swap agreement; however, Trident now receives LIBOR thus offsetting the floating rate risk in the original loan • Trident’s total payment will therefore be 7.25% (5.75% + 1.50%)

20. Trident Corporation:Swapping to Fixed Rates

21. Trident Corp:Swapping Dollars into Swiss francs • After raising the $10 million in floating rate financing and swapping into fixed rate payments, Trident decides it would prefer to make its debt-service payments in Swiss francs • Trident signed a 3-year contract with a Swiss buyer, thus providing a stream of cash flows in Swiss francs • Trident would now enter into a three-year pay Swiss francs and receive US dollars currency swap • Both interest rates are fixed • Trident will pay 2.01% (ask rate) fixed Sfr interest and receive 5.56% (bid rate) fixed US dollars

22. Trident Corp:Swapping Dollars into Swiss francs

23. Trident Corp:Swapping Dollars into Swiss francs • The spot rate in effect on the date of the agreement establishes what the notional principal is in the target currency • In this case, Trident is swapping into francs, at Sfr1.50/$. • This is a notional amount of Sfr15,000,000. Thus Trident is committing to payments of Sfr301,500 (2.01%  Sfr15,000,000 = Sfr301,500) • Unlike an interest rate swap, the notional amounts are part of the swap agreement

24. Trident Corp:Swapping Dollars into Swiss francs

25. Trident Corporation:Unwinding Swaps • As with the original loan agreement, a swap can be entered or unwound if viewpoints change or other developments occur • Assume that the three-year contract with the Swiss buyer terminates after one year, Trident no longer needs the currency swap • Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates then converting the target currency back to the home currency

26. Trident Corporation:Unwinding Swaps • If Trident has two payments of Sfr301,500 and Sfr15,301,500 remaining (interest plus principal in year three) and the 2 year fixed rate for francs is now 2.00%, the PV of Trident’s commitment is francs is

27. Trident Corporation:Unwinding Swaps • At the same time, the PV of the remaining cash flows on the dollar-side of the swap is determined using the current 2 year fixed dollar rate which is now 5.50%

28. Trident Corporation:Unwinding Swaps • Trident’s currency swap, if unwound now, would yield a PV of net inflows of $10,011,078 and a PV of net outflows of Sfr15,002,912. If the current spot rate is Sfr1.4650/$ the net settlement of the swap is • Trident makes a cash payment to the swap dealer of $229,818 to terminate the swap • Trident lost on the swap due to franc appreciation

29. Counterparty Risk • Counterparty Risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations • A firm entering into a swap agreement retains the ultimate responsibility for its debt-service • In the event that a swap counterpart defaults, the payments would cease and the losses associated with the failed swap would be mitigated • The real exposure in a swap is not the total notional principal but the mark-to-market value of the differentials

30. A Three-way Cross Currency Swap • Sometimes firms enter into loan agreements with a swap already in mind, thus creating a debt issuance coupled with a swap from its inception • Example: the Finnish Export Credit agency (FEC), the Province of Ontario, Canada and the Inter-American Development Bank (IADB) all possessed access to ready sources capital but wished debt service in another market • FEC had not raised capital in Canadian dollar Euromarkets and an issuance would be well received; however the FEC had a need for increased debt-service in US dollars, not Canadian dollars

31. A Three-way Cross Currency Swap • Province of Ontario needed Canadian dollars but due to size of provincial borrowings knew that issues would push up its cost of funds; there was however an attractive market in US dollars • IADB had a need for additional US dollar denominated debt-service; however it already raised most of its debt in the US markets but was a welcome newcomer in the Canadian dollar market • Each borrower determined its initial debt amounts and maturities expressly with the needs of the swap

32. Province of Ontario (Canada) C$150 million C$300 million $260 million $130 million Borrows $390 million at US Treasury + 48 bp Finish Export Credit (Finland) Inter-American Development Bank Borrows C$300 million at Canadian Treasury + 47 bp Borrows C$150 million at Canadian Treasury + 44 bp A Three-way Cross Currency Swap

33. Summary of Learning Objectives • The single largest interest rate risk of the non-financial firm is debt-service. The debt structure of an MNE will possess differing maturities of debt, different interest rates and different currency denominations • The increasing volatility of world interest rates, combined with increasing use of short-term and variable-rate notes has led many firms to actively manage their interest rate risk

34. Summary of Learning Objectives • The primary sources of interest rate risk to an MNE are short-term borrowing and investing and long-term borrowing • The techniques and instruments used in interest rate risk management resemble those used in currency risk management: the old method of lending and borrowing • The primary instruments include forward rate agreements (FRAs), interest rate futures, forward swaps and interest rate swaps

35. Summary of Learning Objectives • The interest rate and currency swap markets allow firms that have limited access to specific currencies and interest rate structures to gain access at relatively low costs • A cross currency interest rate swap allows a firm to alter both the currency of denomination of the cash flows but also to alter the fixed-to-floating or floating-to-fixed interest rate structure