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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