Ch 10: Swaps Tools for Hedging Risk

1. 1 Ch 10: SwapsTools for Hedging Risk Short/Medium Term (usually < 12 months): Forward contracts: exchange rate risk. Futures contracts & options: alternative tools for hedging exchange rate risk. Long Term (usually > 1 year): Interest rate swaps: hedge interest rate risk. Currency swaps: hedge exchange rate risk.

2. 2 Swap Market Efficiency Market completeness. Financing tailored to individual borrower�s needs. Reflects fact that not all types of debt instruments are available to all types of borrowers. Enables both counterparties to obtain financing that is more suitable for their asset maturity structures.

3. 3 Definitions In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. The counterparties will take offsetting positions in the swap. Usually a swap bank acts as matchmaker. 2 types of swaps: Interest rate Currency

4. 4 Single Currency Interest Rate Swaps �Plain vanilla� fixed-for-floating swaps are often just called interest rate swaps. The only difference between the 2 obligations is the structure of the interest rate. Intuition: Each party has a comparative advantage in borrowing in one type of structure but prefers the other. When? To better match cash inflows/outflows and/or to obtain cash savings.

5. 5 Cross-Currency Interest Rate Swaps This is often called a currency swap. Fixed for fixed rate debt service in two (or more) currencies. The only difference between the 2 obligations is the currency in which they are denominated. Intuition: Each party has a comparative advantage in borrowing in one currency but needs the other currency. When? To obtain debt financing in the swapped denomination at lower cost and/or to hedge forex risk.

6. 6 Global OTC Derivatives Market Notional amounts outstanding in US$ bn.

7. 7 US$ & Euro Dominate Interest Rate Swaps

8. 8 Trends in Interest Rate Swaps Dollar-denominated swaps have grown steadily in recent years due to a shift in hedging and trading strategies. In the 1st half of 2002, US$ denominated swaps rose 14% to $22 trn. Much of the 2002 increase in Euro- and yen- denominated swaps was due to the currencies� appreciation against the US$. Previously, there was a sharp expansion in Euro-denominated swaps in 2000 following the currency�s introduction. ? Creation of a new benchmark.

9. 9 The Swap Bank A generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty. ? more common because more profitable.

10. 10 �Plain Vanilla� Interest Rate Swap Bank A is a AAA-rated international bank located in the U.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. Why?

11. 11 Example cont�d (2) Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5-year FRNs at LIBOR + � percent. Firm B would prefer to borrow at a fixed rate. Why?

12. 12 Example cont�d (3) The borrowing opportunities of the two firms are summarized in the following table:

13. 13 Example cont�d (4)

14. 14 Example cont�d (5)

15. 15 Example cont�d (6)

16. 16 Example cont�d (7)

17. 17 Example cont�d (8)

18. 18 Example cont�d (9)

19. 19 The Quality Spread Differential The QSD represents the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. In the above example, company B is less credit-worthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

20. 20 Summary of Interest Rate Swap Ex. Interest rate swaps will be carried out when two borrowers (e.g. Bank A and Company B) are unable to obtain their preferred type of loan at preferential rates. They will arrange a swap transaction via a swap bank who acts as a middleman. The transaction is conducted via the swap bank because It is difficult for the two borrowers to contact one another directly and/or the swap bank enables the counterparties to complete the transaction at lower cost.

21. 21 An Example of a Currency Swap (1) Suppose a U.S. MNE wants to finance a �10,000,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and then exchange their dollars for pounds. But this will give them exchange rate risk: financing a sterling project with dollars. Alternatively, they could borrow pounds in the international bond market, but pay a lot since they are not as well known abroad.

22. 22 If they can find a British MNE with a mirror-image financing need, they may both benefit from a swap. If the exchange rate is S0($/�) = $1.60/�, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000. An Example of a Currency Swap (2)

23. 23 Consider two firms A and B: firm A is a U.S.�based multinational and firm B is a U.K.�based multinational. Both firms wish to finance a project in each other�s country of the same size. Their borrowing opportunities are as stated in the table below. An Example of a Currency Swap (3)

24. 24 A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B. A pays .4% less to borrow in pounds than B: Comparative Advantage as the Basis for Swaps (1)

25. 25 B has a comparative advantage in borrowing in �. B pays 2% more to borrow in dollars than A. Comparative Advantage as the Basis for Swaps (2)

26. 26 Comparative Advantage as the Basis for Swaps (3a) To lower the cost of its pound debt, Company A will go through a swap bank to borrow pounds at any rate that is lower than 11.6% � the best rate it can obtain independently. In today�s example, we�ll set this rate to be 11%.

27. 27 Comparative Advantage as the Basis for Swaps (3b) Company B will go through a swap bank to borrow dollars at any rate that is lower than 10% � the best rate it can obtain independently. In today�s example we�ll set this rate to be 9.4%.

28. 28 An Example of a Currency Swap (4)

29. 29 Cost/Benefit Analysis:Company A�s perspective Company A will borrow $16mn externally at $8%. Company A will lend the swap bank $16mn at $8%. In turn, the swap bank will lend company A pounds at �11%. Net cost: $8% - $8% + �11% = �11% < �11.6%. Saves �0.6% by borrowing pounds from the swap bank instead of directly tapping the capital markets.

30. 30 An Example of a Currency Swap (5)

31. 31 Cost/Benefit Analysis Company B Company B will borrow �10mn externally at �12%. Company B will lend the swap bank �10mn at �12%. In turn, the swap bank will lend company B dollars at $9.4%. Net cost: �12% - �12% + $9.4% = $9.4% < $10.0% Saves $0.6% by borrowing dollars from the swap bank instead of directly tapping the capital markets.

32. 32 An Example of a Currency Swap (6)

33. 33 Cost/Benefit Analysis Swap Bank The swap bank makes money too: 1.4% of $16 million financed with 1% of �10 million per year for 5 years. How? Company A lends the swap bank $16mn at 8% and Company B borrows $16 mn at 9.4%. This yields a 1.4% annual return on $16mn ?$224,000. Company A borrows �10 mn at �11% and Company B lends the bank �10 mn at �12%. The swap bank therefore pays 1% per year for �10 mn ? �100,000.

34. 34 Cost/Benefit Analysis Swap Bank At the current exchange rate of S0($/�) = $1.60/�, that is a gain of $64,000 per year. However, the actual annual gain would be $224,000 - �100,000 * ST($/�). If S0($/�) < ST($/�) (i.e. the pound appreciated), then the value of this swap would decrease. Thus we see that the swap bank faces a variety of risks. Some of these risks might be offset in other swaps.

35. 35 Risks of Swaps Interest Rate Risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

36. 36 Risks of Swaps (continued) Credit Risk This is the major risk faced by a swap dealer�the risk that a counter party will default on its end of the swap. Mismatch Risk It�s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. Sovereign Risk The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

37. 37 Swaps can take many forms�