Chapter 7 Currency Swaps Swaps Markets by slappypappy127

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									                                    Chapter 7
             Currency Swaps & Swaps Markets
           Learning objectives
            Parallel loans: A precursor to the swap
            Currency swaps
                 – Swap pricing schedules
                 – Fully covered swap pricing
                 – Hedging exposure to currency risk
            Other types of swaps
                 – Interest rate swaps
                 – Commodity swaps

Butler, Multinational Finance, 4e                      7-1
            Motivation for a currency swap

             A     small UK firm wants to convert
                 floating-rate £ debt into fixed-rate $
                 debt to offset its revenues from US
                 sales
              The   UK firm’s alternatives include
                 - A direct issue in US dollars
                 - A parallel loan that trades floating-
                   rate £ debt for the fixed-rate $ debt
                   of a U.S. company

Parallel loans                                             7-2
                         A parallel loan

         Borrow   in your local currency and then
           trade for the debt of a foreign counterparty
         Parallel loans provide access to new
           capital markets
             - Legally circumvent taxes on cross-border
               currency transactions
             - Provide foreign-source financing for foreign
               subsidiaries
             - May lower the firm’s cost of capital

Parallel loans                                                7-3
                 Problems with parallel loans


           The  foreign counterparty may have
             default risk
           Parallel loans must be capitalized
             on the balance sheet
           Search     costs can be high


Parallel loans                                   7-4
                   The swap contract

         The   solution: Package the parallel loans
           into a single legal agreement called the
           swap contract
            - This reduced the default risk of parallel
              loans via the rights of set-off
            - Swaps need not be capitalized on the
              balance sheet
            - As volume in the swaps market rose,
              search costs were reduced and
              liquidity increased
Currency swaps                                            7-5
                   Currency swaps…
           “I’ll pay yours if you pay mine”

         Currency    Swap
            - An agreement to exchange a principal
              amount of two currencies and, after a
              pre-arranged length of time, re-
              exchange the original principal
            - Interest payments are also usually
              swapped during the life of the
              contract

Currency swaps                                        7-6
       Development of the swaps market
      1981
         - Salomon Brothers engineers the first currency
           swap between the World Bank and IBM

      Early     1980s
         - Customized, low-volume, high-margin deals
      Late      1980s and 1990s
         - Commercial and investment banks begin to
           serve as swaps dealers
         - Swaps turn into a standardized, high-volume,
           low-margin business
         - Volume and liquidity grow
Currency swaps                                             7-7
        A note on day count conventions

       Adjusting     for day count conventions
           - Bond equivalent yields (BEY) are quoted
             as Actual/365
           - Money market yields (MMY) are quoted
             as Actual/360
           - The relation between the two is

                   MMY = BEY (360/365)

Currency swaps                                         7-8
    Example of a currency coupon swap

       Ford     Motor Company (U.S.)
           - Ford has $100 million in 2-year, fixed-rate dollar
             debt at 6.62% compounded semiannually (sa)
           - Ford wants floating-rate Indian rupee debt

       Tata     Motors (India)
           - TM has Rupee 4.032 billion in 2-year, floating-
             rate rupee debt with semiannual payments
             priced at LIBOR+60 bps
           - TM wants fixed-rate U.S. dollar debt


Currency swaps                                                    7-9
           Pricing schedule for a Rupee/$
               currency coupon swap

                 Maturity       Bid ($)     Ask ($)
                 2 years        6.04%       6.20%
                 All quotes are U.S. dollars semiannual
                 actual/365 against 6-month LIBOR flat
                 in rupees
                         S0Rp/$ = Rp 40.3200/$
                 Assume yield curves are flat, and the
                 dollar is selling at a six-month forward
                 premium of 2.04%
Currency swaps                                              7-10
     TM’s “uncovered” swap cash flows

    TM’s underlying obligation (MMY)

                                       [LIBOR + 30 bps] (Rp)

    Swap bank covers TM’s floating rate rupee obligations
                                            [LIBOR] (Rp)

                                              3.10% ($)


    TM pays fixed-rate dollars to the swap bank

Currency swaps                                              7-11
   TM’s “fully covered” swap cash flows

    TM’s underlying obligation (MMY)

                                        [LIBOR + 30 bps] (Rp)

    Swap bank covers TM’s floating rate rupee obligations
                                        [LIBOR + 30 bps] (Rp)

                                              3.10% ($)
                                              spread ($)

    TM pays fixed-rate dollars to the swap bank including a
    spread (or premium) to cover their underlying obligation
Currency swaps                                                 7-12
                 A “fully covered” swap
             (floating-to-fixed conversion)

   1. Convert the floating rate (MMY) spread to
      LIBOR into BEY = MMY (365/360)
   2. Find the corresponding spread in the other
      currency from equation (7.2)
                  T       rd            T       rf
                                d t
                                                     f t   (7.2)
                 t 1 (1  i t    )    t 1 (1  i t    )

   3. Calculate the fixed rate payment from the
      spread and the swap ask rate
Currency swaps                                                       7-13
      1. Convert the floating rate (MMY)
         spread to LIBOR into BEY

          TM’s 30 bp spread to LIBOR is quoted as
          a money market yield (MMY)

          The bond equivalent yield is
                 BEY = MMY (365/360)
                     = (30 bps) (365/360)
                     = 30.4167 bps every six months

          or 60.8333 bps per year (sa)

Currency swaps                                        7-14
      2. Find the corresponding spread
         in the other currency
          The $ swap mid-rate is 6.12 percent or
           i$ = 3.06 percent per six months
          The dollar is at a 6-month forward
           premium of 2.04%, so the 6-month
           rupee interest rate is
                 iRp = (1+i$)(F1Rp/$/S0Rp/$)–1
                     = (1.0306)(1.0204)–1
                     = 5.162424% per six months

Currency swaps                                      7-15
       2. Find the corresponding spread
          in the other currency
      Equation (7.2) is used to find an equivalent
       fixed rate spread in another currency
                              d                      f
                  T       r              T       r
                                 d t
                                                       f t
                                                               (7.2)
                 t 1 (1  i t     )    t 1 (1  i t     )
      Yield curves are flat in our problem, so the
       following values are useful:
       PVIFA$ (3.060000%, 4 periods) = 3.711771
       PVIFARp (5.162424%, 4 periods) = 3.532613
Currency swaps                                                         7-16
      2. Find the corresponding spread
         in the other currency

        TM’s LIBOR spread is 30.4167 bps in rupees
        Solving equation (7.2) for the equivalent
         dollar spread r$ results in
                 4        r$        4 (30.4167 bps)
                              t
                                                   t   (7.2)
                 t 1 (1.0306)    t 1 (1.0516242 4)


         or r$ = (30.4167 bps) (3.532613 / 3.711771)
               = 28.9485 bps per six months
Currency swaps                                               7-17
      3. Calculate the payment from the
         swap ask rate and the spread
       TM’s all-in cost of fixed rate dollar debt is

                   3.100000 percent (swap ask rate)
                 + 0.289485 percent (spread)
            r$ = 3.389485 percent per six months

       or 6.778970 percent per year
          compounded semi-annually

       or APR = (1.03389485)2 – 1 = 6.893857%
Currency swaps                                         7-18
   Ford’s “uncovered” swap cash flows

     Ford’s underlying obligation (BEY)

                                                 3.31% ($)

     Swap bank pays Ford fixed-rate dollars
                                                 +3.02% ($)

                                              LIBOR (rupee)


     Ford pays rupees to the swap bank at LIBOR flat (MMY)

Currency swaps                                                 7-19
 Ford’s “fully covered” swap cash flows

     Ford’s underlying obligation

                                                  3.31% ($)

     Swap bank covers Ford’s fixed-rate dollars
                                                  +3.31% ($)

                                            LIBOR (Rp)
                                            spread (Rp)

     Ford pays rupees at LIBOR plus a spread

Currency swaps                                                 7-20
                 A “fully covered” swap
             (fixed-to-floating conversion)

    1. Find the spread over the swap bid rate
    2. Find the corresponding spread in the other
       currency from equation (7.2)
                  T       rd            T       rf
                                d t
                                                     f t
                                                             (7.2)
                 t 1 (1  i t    )    t 1 (1  i t    )

    3. Convert this BEY spread to a MMY spread
       over LIBOR

Currency swaps                                                       7-21
      1. Calculate the spread to the
         swap bid rate


     Ford’s dollar spread to the swap bid rate is
                   3.31 percent (fixed interest rate)
                 – 3.02 percent (swap bid rate)
          r$ = 0.29 percent every six months ($)




Currency swaps                                          7-22
      2. Find the corresponding
         premium in the other currency

         Solving equation (7.2) for the rupee
          spread rRp that yields the same present
          value as the dollar spread results in
                 4          r Rp         4 (29 bps)
                                   t
                                                       (7.2)
                 t 1 (1.0516242 4)    t 1 (1.0306) t

          or rRp = (29 bps) (3.711771 / 3.532613 )
                 = 30.4708 bps per six months (BEY)

Currency swaps                                                   7-23
      3. Convert the BEY spread to a
         floating rate MMY spread
       Ford’s 30.4708 bp spread is quoted as a
       bond equivalent yield (BEY)

       The corresponding money market yield is
                 MMY = BEY (360/365)
                     = (30.4708 bps) (360/365)
                     = 30.0533 bps every six months

       Ford’s all-in cost of floating rate rupee debt
       is LIBOR + 60.1067 bps (sa)
Currency swaps                                          7-24
                    The swap bank’s
                 “uncovered” cash flows
    TM as counterparty                3.10% ($)

                                     LIBOR (Rp)

    Ford as counterparty             LIBOR (Rp)

                                     3.02% ($)

    The swap bank’s net cash flows

                                      0.08% ($)
Currency swaps                                     7-25
                       The swap bank’s
                 “fully covered” cash flows
    TM as counterparty                   3.389485% ($)

                                LIBOR + 30.0000 bps] (Rp)

    Ford as counterparty        [LIBOR + 30.0533 bps] (Rp)

                                         3.310000% ($)

    The swap bank’s net cash flows       0.0533 bps (Rp)

                                         0.079485% ($)
Currency swaps                                              7-26
                       The swap bank’s
                 “fully covered” cash flows
      BEY (Rp) = (0.0533 bps)(365/360) = 0.0540 bps


                      4    (0.0541 bps)      4      r$
      BEY ($):                         t
                                          
                     t 1 (1.0516242 4)    t 1 (1.0306) t
                r$ = BEY ($) = 0.0515 bps, or 0.000515%

      Swap bank’s return as a dollar bond equivalent yield
        = 0.079485% + 0.000515% = 0.08 percent
        or 8 bps per six-month period

Currency swaps                                               7-27
                       Interest rate swaps


             Interest    rate swap
                 - Same as a currency swap, but in
                   a single currency
                 - A difference check is paid during
                   the life of the swap
                 - The principal is purely notional,
                   and is not swapped

Other types of swaps                                   7-28
                 Floating-to-fixed conversion
                   for an interest rate swap

     1. Convert the floating rate (MMY) spread to
        LIBOR into BEY = MMY (365/360)

     2. Find the corresponding spread in the other
        currency from equation (7.2)
          Step 2 is no longer necessary…

     3. Calculate the fixed rate payment from the
        spread and the swap ask rate

Currency swaps                                       7-29
                 Fixed-to-floating conversion
                   for an interest rate swap

     1. Find the spread over the swap bid rate

     2. Find the corresponding spread in the other
        currency from equation (7.2)
          Step 2 is no longer necessary…

     3. Convert this BEY spread to a MMY spread
        over LIBOR


Currency swaps                                       7-30
                           Commodity swaps

                Commodity     swaps are traded
                   against a variety of commodity
                   prices including
                       - Oil
                       - Gold
                       - Pork belly prices

                Most    commodity swaps are fixed-
                   for-floating swaps based upon
                   spot prices

Other types of swaps                                  7-31
                       An oil-for-euro swap


                A   Dutch chemicals manufacturer
                   uses 500,000 barrels of oil every 3
                   months
                 The   manufacturer has contracted
                   to sell its products at a fixed euro
                   price for 5 years and wants to fix its
                   input costs in euros as well


Other types of swaps                                        7-32
                       An oil price swap
           Spot oil
           market
                 Spot oil
        Oil
                  price
            Dutch         Spot oil price    Commodity
             firm         Fixed rate ($s)   swap dealer




Other types of swaps                                      7-33
                       An oil price swap
           Spot oil
           market
                 Spot oil
        Oil
                  price
            Dutch         Spot oil price    Commodity
             firm         Fixed rate ($s)   swap dealer

            Counter      Fixed rate ($s)    Interest rate
             party         LIBOR ($s)       swap dealer




Other types of swaps                                        7-34
                       An oil price swap
           Spot oil
           market
                 Spot oil
        Oil
                  price
            Dutch         Spot oil price    Commodity
             firm         Fixed rate ($s)   swap dealer

            Counter      Fixed rate ($s)    Interest rate
             party         LIBOR ($s)       swap dealer

            Counter        LIBOR ($s)        Currency
             party        Fixed rate (€s)   swap dealer

Other types of swaps                                        7-35
                       A debt-for-equity swap

      A   London bank holds a volatile portfolio of
         H-shares that is highly correlated with the
         Hang Seng China Enterprises index
       The  bank decides it would rather hold fixed-
         rate pound sterling debt
       Combine   the following three swaps to
         achieve the desired result:
           - A fixed-for-floating £ interest rate swap
           - A pound-for-HK$ currency swap
           - An equity swap for fixed-rate HK$ debt

Other types of swaps                                     7-36
             Swapping H-shares for £ debt
           H-share
           portfolio
 H-share
  return
       London           H-share return     Equity swap
        bank           Fixed rate (HK$s)     dealer




Other types of swaps                                     7-37
             Swapping H-shares for £ debt
           H-share
           portfolio
 H-share
  return
       London           H-share return     Equity swap
        bank           Fixed rate (HK$s)     dealer

           London      Fixed rate (HK$s)    Currency
            bank          LIBOR (£s)       swap dealer




Other types of swaps                                     7-38
             Swapping H-shares for £ debt
           H-share
           portfolio
 H-share
  return
       London           H-share return     Equity swap
        bank           Fixed rate (HK$s)     dealer

           London      Fixed rate (HK$s)    Currency
            bank          LIBOR (£s)       swap dealer

           London         LIBOR (£s)       Interest rate
            bank        Fixed rate (£s)    swap dealer

Other types of swaps                                       7-39
                            Swaptions

        A   swaption is a swap with one or more
           options attached
             - Interest rate ceilings or floors
             - Exchange rate caps
             - Multiple options (e.g. cylinder options)

         The  option component of a swaption is on
           the underlying fixed-rate bond and is
           priced accordingly


Other types of swaps                                      7-40

								
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