Get documents about "Chapter 7 Currency Swaps Swaps Markets
Document Sample
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
Related docs
