SWAPS

1. SWAPS • The Short-Term Currency Swap • An illustration: • Bank of England (BoE) wants to borrow USD from the Bundesbank (Buba). Buba asks, as security, an equivalent amount of GBP (to be deposited by the BoE with the Buba). Barring default, on the expiration day the USD and the GBP would each be returned, with interest, to the respective owners • Example • S = USD/GBP 2.5, r$ = 3%, r£ = 5%. • time t: BoE receives USD 100m from the Buba for six months, deposits GBP 100m/2.5 = GBP 40m into an escrow account with the Buba. • time T: the Buba returns GBP 40m ¥ 1.05 = 42m, and the BoE returns USD 100m ¥ 1.03 = USD 103m

2. SWAPS • Two ways to view the traditional short-time swap contract • View 1: two mutual loan contracts, one for USD 100m to the Bank of England, and the other for GBP 40m to the Bundesbank, with a right-of-offset clause linking the two loans. • “if one party fails to fulfill its obligations, then the other party is exonerated from its normal obligations too, and can sue the defaulting party if any losses occur”

3. SWAPS • Two ways to view the traditional short-time swap contract • View 2: a spot sale by the Bundesbank of USD 100m for GBP, combined with a six month forward purchase of USD 103m at • 103/42 = 2.45238 = USD/GBP 2.5 ¥ 1.03/1.05 = F.

4. SWAPS • Why short-term Swaps exist? • 1. Safety • 2. Reduction of Transaction Costs • 3. Tax Avoidance • 4. Religious objections against interest • 5. Fictitious Transactions

5. SWAPS • Why short-term Swaps exist? (cont.) • 1. Safety: • Example • Repurchase order (repo): an investor in need of short-term financing • sells low-risk assets (like T-bills) to a lender, and buys them back • under a short-term forward contract • Low-risk loan fi low bid-ask spread ('haircut')

6. SWAPS • Why short-term Swaps exist? (cont.) • 2. Reduction of transaction costs: • If an investor intends to reverse the transaction • Example • A French investor is optimistic about $ returns on US stocks, but not about the $ itself. She buys spot USD to invest in US stocks, and sells USD forward to hedge the $ risk

7. SWAPS • Why short-term Swaps exist? (cont.) • 3. Tax Avoidance: • When capital gains are taxed at a lower rate • Example • Buy 10 kilos of gold from a bank at the spot price St = LUF 5m • and sell it back (forward) at Ft,T = St (1+rt,T) = 5.25m • This is a disguised deposit of LUF 5m at 5%, but the return is • a capital gain

8. SWAPS • Why short-term Swaps exist? (cont.) • 4. Religious objections against interest: Catholic Church, Islam • 5. Fictitious transactions: • Hide losses by selling assets at inflated prices (and buy them • back at similarly inflated forward prices) • Hide the ownership of assets by conjuring them away • around the reporting date

9. SWAPS • Back-to-Back and Parallel Loans • The right-of-offset was already used in back-to-back and parallel loans • Back-to-back loans: • UK institutional investor (UKII) wants to invest in US. But “investment • dollar premium” made foreign investments expensive to UK • investors. Thus, UKII wants to avoid the spot market at t and T, • by setting up a deal with a foreign firm (USCo) that wants to • invest in the UK: • USCo lends USD to UKII • UKII lends GBP to USCo (or its UK subsidiary) • Right of offset between these two loan contracts: if (say) UKII • cannot pay back, USCo can withhold its payments and sue • for the net loss (if any)

10. SWAPS • Back-to-back loans: (cont.)

11. SWAPS • Parallel loans: • USCo faces capital export controls, cannot export USD to its • UK subsidiary • UKCo wants to lend to its US subsidiary, but there is a • dollar premium • Both can avoid the spot market by granting loans to each • other (or to each other’s subsidiary), with a right of offset • in the two loan contracts

12. SWAPS • The 1981 IBM/World Bank Currency Swap: • IBM wanted to call its DEM- and CHF debt: the USD had • appreciated considerably and the DEM and CHF interest • rates had also gone up. But this would be costly: • Exchange transaction costs when IBM buys DEM and CHF • Call premium: IBM has to pay more than the DEM and • CHF face value • Issuing costs when IBM issues new USD bonds. • Capital gains taxes on realized gain

13. SWAPS • The 1981 IBM/World Bank Currency Swap:(cont.) • The World Bank (WB) wanted to borrow DEM and CHF to lend • to its own customers • issuing costs on new CHF and DEM bonds • Note that IBM wants to withdraw CHF and DEM bonds (at a rather high cost) while WB wants to issue CHF and DEM bonds (also at a cost). To avoid most of these costs, IBM and WB agreed that WB would take over IBM’s foreign debt instead

14. SWAPS • The 1981 IBM/World Bank Currency Swap:(cont.) • Specifically, • WB borrows USD instead of DEM, CHF. With the proceeds it buys • spot CHF and DEM for its loans • WB undertakes to deliver to IBM the DEM and CHF necessary • to service IBM’s old DEM and CHF loans, • ... while IBM promised to provide the WB with the USD needed • to service the WB's (new) USD loan;

15. SWAPS • The 1981 IBM/World Bank Currency Swap:(cont.) • Right of offset between the undertakings Equal initial value principle: the present value of IBM's (USD) payments to the WB is equal to the present value of the (DEM and CHF) inflows received from the WB.

16. SWAPS • The 1981 IBM/World Bank Currency Swap:(cont.) • Example • IBM’s DEM debt is DEM 10m at 5% maturing within 5 years • The current 5-year DEM interest rate is 10% and • St = USD/DEM 0.4 • Market value of service payments: • (1) DEM 10m ¥ [1 + (.05 - .1) ¥ a(10 %, 5 years)] • = DEM 8.105m • or 8.105 ¥ .4 = USD 3.242m. So the USD loan should also be • worth USD 3.242m.

17. SWAPS • The Fixed-for-Fixed Currency Swap • First review the short-term swap: • the contract has zero initial value • The spot and forward contracts each have zero value because • the amounts are exchanged at the going spot and forward rate • Also in the “mutual loan” view, zero initial value holds • [example (Buba/BoE): 5% on GBP, 3% on USD, St=2.5]: • PVUSD = = USD 100 ; and • PVGBP = = GBP 40, or USD 100

18. SWAPS • The Fixed-for-Fixed Currency Swap (cont.) • the rates used for setting the forward rate or, equivalently, • for discounting the promised payments are the (near-riskless) • short-term interbank rates: • default risk is limited by the forward contract’s right-of-offset • remaining risks are largely eliminated by screening of • the customers, and by margins or other pledges

19. SWAPS • Characteristics of the Modern Currency Swap • Definition. Two parties agree to: • exchange, at time t, two initially equivalent principals • denominated in different currencies • return these principals to each other at T • pay the normal interest, periodically, to each other on the • amounts borrowed

20. SWAPS • Characteristics of the Modern Currency Swap (cont.) • The deal is structured as one single contract, with a right of offset • Example Leg 1 (DEM) leg 2 (USD) 18m at 8% 10m at 7% (“lent”) (“borrowed”) Initial exchange of principals <DEM 18.0m> USD 10.0m annual interest payments DEM 1.44m <USD 0.7m> payment of principal at T DEM 18.0m <USD10.0m>

21. SWAPS • Characteristics of the Modern Currency Swap (cont.) • Swap rates The interest payments for each currency are based • on the currency's "swap (interest) rate"—yields at par for • near-riskless bonds with the same maturity as the swap • Why riskfree rates? • right-of-offset clause; sometimes margin is posted probability • f default is small: screening, 'credit trigger' the uncertainty • about the bank’s inflows is the same as the uncertainty • about the bank’s outflow side. Thus, the corrections for • (minute) risk virtually cancel out

22. SWAPS • Characteristics of the Modern Currency Swap (cont.) • Zero Initial value The initial exchange of principals is a • zero-value transaction because the amounts are initially • equivalent. The future interest payments and amortization • have equal present values, too • Example • (2) PVUSD = + = USD 10m, • (3) PVDEM = + = DEM 18m • which implies that the PV in USD is 18m/1.8 = USD 10m

23. SWAPS • Characteristics of the Modern Currency Swap (cont.) • Costs A commission of, say, USD 500 on a USD 1m swap, • for each payment to be made. Most often this fee is built into • the interest rates, which would raise or lower the quoted rate • by a few basis points • Sometimes an equivalent up-front fee is asked • Example • 7-year yields at par are 7.17% on USD and 9.9% on DEM. • The swap dealer quotes: • USD 7.13% - 7.21% • DEM 9.58% - 9.95% • If your swap contract is one where you "borrow" DEM and • "lend" USD, you pay 9.95% on the DEM, and you receive • 7.13% on the USD

24. SWAPS • Coupon Swaps (Fixed-for-Floating) • Characteristics of the Fixed-for-Floating Swap • Example • An AA Irish company wants to borrow NZD to finance (and • partially hedge) its direct investment in New Zealand. • Better conditions in London than in Wellington preference • for fixed-rate loans, but spread on revolving bank loans is • lower than spread on fixed-rate Eurobonds: • [LIBOR+1%] vs 19% [= swap rate + 3%]

25. SWAPS • Coupon Swaps (Fixed-for-Floating) • Characteristics of the Fixed-for-Floating Swap (cont.) • The company borrows NZD at the (risk-free) swap rate (16%) • plus the spread of 1% it can obtain in the "best" market (the • floating-rate Eurobank-loan market)

26. SWAPS • Base Swaps • Example: IN: T-bill rate / OUT: Eurodollar (LIBOR) • Why? • To speculate on the TED spread • (For a swap dealer): to hedge two (unrelated) coupon • swaps—one where IN is LIBOR and OUT is T-bill

27. SWAPS • Cross-Currency Swaps

28. SWAPS • Cocktail Swap

29. SWAPS • Conclusions • Swaps allow a company to • borrow in the market where it can obtain the lowest spread • exchange the risk-free component of the loan’s service • payments for the risk free component of a another loan • that is thought to be more suitable

30. SWAPS • Case. An Interest Rate Swap: Will it work? Basket Corporation Metro Bank Sushi Bank Fixed Rate Payer 12% Fixed Floating Rate Swap LIBID (-)1/8% Target Rates At least 12 basis points Basket Basket Fixed Reference Rate: - 7 year note - All in cost 127/8% = 12.875% Floating Reference Rate: - Commercial - Paper rate + 1/2% fee 93/8 + 1/2% = 97/8% Sushi Bank can issue 7-yr Eurobond at 12%

31. SWAPS • Case. An Interest Rate Swap: Will it work? (cont.) • LIBOR (overnight) = 9% • Basis Swap7 days = 91/8% • 1 month = 92/8% • 3 months = 93/8% • 6 months = 95/8% • 1 year = 97/8% • Total Gain/Loss: + 109.5 basis points • - 50.0 basis points • for basket + 59.5 basis points CP + 1/4% Vs. LIBOR

32. SWAPS • Case. An Interest Rate Swap: Will it work? (cont.) • From Sushi Bank: • Point of View: • Sushi receives reference: 11.66% ie 112/3% • 12% • Sushi pays: LIBOR - 1/2% • Reference: LIBOR - 1/8% • Total Gain to Sushi Bank: 1/3 - 1/8% = 1/12% • 3/8 - 1/3 = (9-8)/24 = 1/24% 1/3% loss (-) 3/8% gain

33. SWAPS • Case. An Interest Rate Swap: Will it work? (cont.) • Gain to Metro Bank: 12 basis points • 1. Swap is successful • 2. Default Risk of Counter Parties