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. 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

3. 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%)

4. Trident Corporation:Swapping to Fixed Rates

5. 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

6. Trident Corp:Swapping Dollars into Swiss francs

7. 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

8. Trident Corp:Swapping Dollars into Swiss francs

9. 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

10. 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

11. 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%

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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