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Finance 476 Swaps

Finance 476 Swaps. Swaps. swaps are a form of derivative security swaps come in many different forms we will look at: FOREX swaps, interest rate swaps, currency swaps these have the largest established markets, but there are other types

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Finance 476 Swaps

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  1. Finance 476Swaps

  2. Swaps • swaps are a form of derivative security • swaps come in many different forms • we will look at: FOREX swaps, interest rate swaps, currency swaps • these have the largest established markets, but there are other types • all swaps are essentially financial contracts in which one party trades (swaps) one set of cashflows for another set of cashflows

  3. FOREX Swaps • FOREX swap = an spot exchange of currencies combined with a forward agreement entered simultaneously • in a FOREX swap, the parties agree to trade the currencies today (at spot rate) and then trade them back in the future (at the forward rate) • in the inter-bank market, these are actually more popular than outright forwards • FOREX swaps may be used by speculators, or by firms to help their underlying business

  4. Speculation with FOREX Swaps • a swap trader is really trading the difference between spot and forward rates • since the difference is determined by interest rate differentials, a FOREX swap position is really just a bet on interest rates • what makes profit or loss is change in interest differential between two currencies

  5. FOREX Swap example Swap trader enters deal, long 1 million SFr spot (for $US) and short 1 million SFr 30 days forward. 30 day eurocurrency rates: 8.5% for SFr 6% for $US spot exchange rate = 5.4000 SFr/$US From above, can calculate that 30 day forward rate = 5.4112 SFr/$US

  6. FOREX Swap example (cont.) • Scenario 1: • spot rate suddenly changes to 5.4500 SFr/$US • Note: this is a dramatic change • (a) Loss on spot arm of swap.

  7. (b) gain on forward arm of swap • can show that new forward rate will be 5.4613 SFr/$US • Therefore, gain in 30 days: • Gain now: Net result for swap = 1686.80 - 1698.95 = -$12.15 US Note: very small loss on a large change in spot rate.

  8. FOREX Swap example (cont.) • Scenario 2: • spot rate does not change • 30 day interest rates change to: 8.7% for SFr • 7% for $US • no profit/loss on spot arm of swap • on forward arm, new forward rate is 5.408 SFr/$US • Gain in 30 days:

  9. Gain now: Main Point: For FOREX swaps, spot rate changes have an effect, but a very small one (especially on short term swaps , which are most common), changes in interest rate differentials are far more important. FOREX Swaps are essentially viewed as bets on interest rate differentials.

  10. FOREX Swaps and Short Term Financing • major use of FOREX swaps to firms: • provide short term financing in a foreign currency • can provide financing in a currency that otherwise • the firm does not have access to • can provide financing in a foreign currency at a • reasonable implied interest rate

  11. Short Term Financing - Line of Credit • Canadian firm needs access to capital for one year • arranges a $800,000 line of credit at 5% • firm draws down LOC today, use capital for one year in business, then pay off LOC • in one year give $800,000 back to bank, but owes additional $40,000

  12. Foreign Currency Lines of Credit and Swaps • Canadian firm has operations in Europe, would like LOC in euros. Either: • cannot get one • would have to pay very high rate (since unknown to European banks) • say firm needs access to 1,000,000 euros for one year. After one year, the capital will be freed up from business • From Canadian bank, can get $800,000 LOC at 5.25% rate

  13. Foreign Currency Lines of Credit and Swaps • Situation: • spot rate = 0.8 CAD/EUR • one year eurocurrency rates: 4% for CAD 3% for EUR • based on information above, one year forward rate = 0.8078 CAD/EUR • firm creates synthetic euro LOC by: drawing down $800,000 LOC and then entering FOREX swap (long euro spot, short euro forward)

  14. spot arm of swap converts Canadian dollars into 1,000,000 euro. • firm can use the euros in its business for the next year, when it has to give them back to fulfill swap • if firm does not need all euros now, simply deposit and take out what needed as need arises (like drawing down an LOC when needed) • assume here that all euros immediately tied up in business • one year later, will owe $844,000 on its LOC • no long re needs euros (hopefully), so will give 1,000,000 EUR to bank to fulfill forward and receive $807,800 in return. • give the $ to bank to pay off LOC, but must pay an additional 844,000 - 807,800 = $36,200

  15. Thus, the euro financing has an implied interest rate of: • Note: euro financing created here actually has lower rate than ethv firm’s available $Can financing • this occurs only because euro is at forward premium • would pay more than the $Can LOC rate if euro at forward discount • Major use of FOREX swaps: creating short term financing for firm’s in foreign currencies • Another major use of FOREX swaps among firms is to extend the maturity of forward contracts.

  16. Interest Rate Swaps • another type of swap • one firm borrows floating rate, one firm borrows fixed rate, the two firms trade their debts • each makes the others interest payments • essentially floating rate debt is swapped into fixed rate • bank acts as middleman • both firms can be better off • very large market • outstanding notional principal of approx. $50 trillion US

  17. Interest Rate Swap - Example • Firm A and firm B both want to borrow $50,000,000 • Firm A has better credit rating • Firm A can borrow at a fixed rate of 5%, or at a floating rate of LIBOR+1% • Firm B can borrow at a fixed rate of 8%, or at a floating rate of LIBOR+3% • Firm A would like to borrow at a floating rate, firm B would like to borrow at a fixed rate

  18. Interest Rate Swap example - (cont.) • Firm B has a comparative advantage in floating rate debt • it pays extra 2% in floating, but pays extra 3% in fixed • relatively speaking, it is not penalized as much in flot5ing rate market • this may indicate some type of inefficiency in debt markets - swaps take advantage of this • Firm A has comparative advantage in fixed rate debt • A’s creditworthiness is valued more there (3% lower rate) than in floating rate (2% lower rate) Each firm should borrow where it has comparative advantage, then enter a swap with its bank to get the type of debt it wants.

  19. Interest Rate Swap example - (cont.) • Firm A borrows $50 million at 5% • enters swap with bank on notional principal of $50 million • firm pays bank payment equal to LIBOR times notional principal • bank pays firm payment equal to 4.4% times notional principal • the payments last for a set maturity • this is A’s swap • Firm B borrows $50 million at LIBOR+3% • enters swap with bank on notional principal of $50 million • firm pays bank payment equal to 4.6% times notional principal • bank pays firm payment equal to LIBOR times notional principal • the payments last for a set maturity • this is B’s swap

  20. Interest Rate Swap example - (cont.) • Note: the floating arm of a swap is normally LIBOR (although it does not have to be), the fixed rates in the swaps could be different, they have been set to the given rates for the example • Overall the situation looks like this: LIBOR LIBOR 5% LIBOR+3% Firm A Bank Firm B 4.4% 4.6%

  21. Interest Rate Swap example - (cont.) Overall result for Firm A: pays (on loan): 5% pays (on swap): LIBOR receives (on swap): 4.4% Net rate being paid: LIBOR+0.6% A borrows fixed but ends up paying floating rate (has swapped into floating), and pays a rate lower than it could get by itself.

  22. Interest Rate Swap example - (cont.) Overall result for Firm B: pays (on loan): LIBOR+3% pays (on swap): 4.6% receives (on swap): LIBOR Net rate being paid: 7.6% B borrows floating but ends up paying fixed rate (has swapped into fixed), and pays a rate lower than it could get by itself.

  23. Interest Rate Swap example - (cont.) Result for bank: pays LIBOR receives LIBOR pays 4.4% receives 4.6% Net profit 0.2% per year on notional principal

  24. Interest Rate Swap example - (cont.) Overall gains: Firm A saves 0.4% over its own rate Firm B saves 0.4% over its own rate Bank earns 0.2% Total gains 1% • The total gains to be had equal the amount of inefficiency in the debt markets. • 3% difference between firms in fixed rate, 2% difference in floating rate • 3% - 2% = 1%

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