Interest Rate _ Currency Swaps

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					           Chapter 14
Interest Rate & Currency Swaps

            To Accompany

                           Slide 14-1
            Chapter 14
 Interest Rate & Currency Swaps
 Learning Objectives
   • Define interest rate risk and demonstrate how it can be
   •   Describe interest rate swaps and show how they can be
       used to manage interest rate risk
   •   Show how interest rate swaps and cross-currency
       swaps can be used to manage both foreign exchange
       and interest rate risk simultaneously

                                                     Slide 14-2
               Interest Rate Risk
 All firms, domestic or multinational, are sensitive to
    interest rate movements
   The single largest interest rate risk of a non-financial
    firm is debt service
    • For an MNE, differing currencies have differing
      interest rates thus making this risk a larger concern
 The second most prevalent source of interest rate risk
    is its holding of interest sensitive securities
   Ever increasing competition has forced financial
    managers to better manage both sides of the balance

                                                       Slide 14-3
              Interest Rate Risk
 Whether it is on the left or right hand side, the
  reference rate of interest calculation merits special
   • The reference rate is the rate of interest used in a
     standardized quotation, loan agreement, or financial
     derivative valuation
   • Most common is LIBOR (London Interbank Offered

                                                       Slide 14-4
Management of Interest Rate Risk
 The management dilemma is the balance between risk
    and return
   Since most treasuries do not act as profit centers, their
    management practices are typically conservative
   Before treasury can take any hedging strategy, it must
    first form an expectation or a directional and/or
    volatility view
   Once management has formed its expectations about
    future interest rate levels and movements, it must then
    choose the appropriate implementation of a strategy

                                                     Slide 14-5
       Credit and Repricing Risk
 Credit Risk or roll-over risk is the possibility that a
  borrower’s creditworthiness at the time of renewing a
  credit, is reclassified by the lender
   • This can result in higher borrowing rates, fees, or even
 Repricing risk is the risk of changes in interest rates
  charged (earned) at the time a financial contract’s rate
  is being reset

                                                      Slide 14-6
        Credit and Repricing Risk
 Example:     Consider a firm facing three debt strategies
   • Strategy #1: Borrow $1 million for 3 years at a fixed
   •   Strategy #2: Borrow $1 million for 3 years at a floating
       rate, LIBOR + 2% to be reset annually
   •   Strategy #3: Borrow $1 million for 1 year at a fixed
       rate, then renew the credit annually
 Although the lowest cost of funds is always a major
  criteria, it is not the only one

                                                       Slide 14-7
        Credit and Repricing Risk
 Strategy #1 assures itself of funding at a known rate
    for the three years; what is sacrificed is the ability to
    enjoy a lower interest rate should rates fall over the
    time period
   Strategy #2 offers what #1 didn’t, flexibility
    (repricing risk). It too assures funding for the three
    years but offers repricing risk when LIBOR changes
   Strategy #3 offers more flexibility and more risk; in
    the second year the firm faces repricing and credit
    risk, thus the funds are not guaranteed for the three
    years and neither is the price

                                                       Slide 14-8
   Trident’s Floating-Rate Loans
 Example using Trident corporation’s loan of US$10
  million serviced with annual payments and the
  principal paid at the end of the third year
   • The loan is priced at US dollar LIBOR + 1.50%;
     LIBOR is reset every year
   • When the loan is drawn down initially (at time 0), an
     up-front fee of 1.50% is charged
   • Trident will not know the actual interest cost until the
     loan has been completely repaid

                                                       Slide 14-9
Trident’s Floating-Rate Loans

                            Slide 14-10
     Trident’s Floating-Rate Loans
   If Trident had wished to manage the interest rate risk
    associated with the loan, it would have a number of
    • Refinancing – Trident could go back to the lender and refinance
        the entire agreement
    •   Forward Rate Agreements (FRAs) – Trident could lock in the
        future interest rate payment in much the same way that exchange
        rates are locked in with forward contracts
    •   Interest Rate Futures
    •   Interest Rate Swaps – Trident could swap the floating rate note
        for a fixed rate note with a swap dealer

                                                              Slide 14-11
Forward Rate Agreements (FRAs)
   A forward rate agreement is an interbank-traded contract to
    buy or sell interest rate payments on a notional principal
    • Example: If Trident wished to lock in the first payment it would
        buy an FRA which locks in a total interest payment at 6.50%
    •   If LIBOR rises above 5.00%, then Trident would receive a cash
        payment from the FRA seller reducing their LIBOR payment to
    •   If LIBOR falls below 5.00% then Trident would pay the FRA
        seller a cash amount increasing their LIBOR payment to 5.00%

                                                              Slide 14-12
            Interest Rate Futures
 Interest Rate futures are widely used; their
    popularity stems from high liquidity of interest rate
    futures markets, simplicity in use, and the rather
    standardized interest rate exposures firms posses
   Traded on an exchange; two most common are the
    Chicago Mercantile Exchange (CME) and the
    Chicago Board of Trade (CBOT)
   The yield is calculated from the settlement price
    • Example: March ’03 contract with settlement price of
      94.76 gives an annual yield of 5.24% (100 – 94.76)

                                                    Slide 14-13
           Interest Rate Futures
 If Trident wanted to hedge a floating rate payment
  due in March ’03 it would sell a futures contract, or
  short the contract
   • If interest rates rise, the futures price will fall and
     Trident can offset its interest payment with the
     proceeds from the sale of the futures contracts
   • If interest rates rise, the futures price will rise and the
     savings from the interest payment due will offset the
     losses from the sale of the futures contracts

                                                         Slide 14-14
  Strategies Using Interest Rate Futures
  Exposure or Position               Futures Action            Interest Rates      Position Outcome

Paying interest on futures date    Sell a futures (short)   If rates go up      Futures price falls;
                                                                                Short earns profit

                                                            If rates go down    Futures price rises;
                                                                                short earns a loss

Earning interest on futures date   Buy a futures (long)     If rates go up      Futures price falls;
                                                                                Long earns a loss

                                                            If rates go down    Futures price rises;
                                                                                Long earns profit

                                                                                    Slide 14-15
              Interest Rate Swaps
   Swaps are contractual agreements to exchange or swap a series
    of cash flows
   If the agreement is for one party to swap its fixed interest
    payment for a floating rate payment, its is termed an interest
    rate swap
   If the agreement is to swap currencies of debt service it is
    termed a currency swap
   A single swap may combine elements of both interest rate and
    currency swap
   The swap itself is not a source of capital but an alteration of
    the cash flows associated with payment

                                                          Slide 14-16
             Interest Rate Swaps
 If firm thought that rates would rise it would enter
    into a swap agreement to pay fixed and receive
    floating in order to protect it from rising debt-service
   If firm thought that rates would fall it would enter
    into a swap agreement to pay floating and receive
    fixed in order to take advantage of lower debt-service
   The cash flows of an interest rate swap are interest
    rates applied to a set amount of capital, no principal is
    swapped only the coupon payments

                                                     Slide 14-17
            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
   • Maria believes that an interest rate swap to pay
     fixed/receive floating would be Trident’s best
   • 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

                                                       Slide 14-18
             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%)

                                                   Slide 14-19
 Trident Corporation:
Swapping to Fixed Rates

                          Slide 14-20
         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
                                                     Slide 14-21
         Trident Corp:
Swapping Dollars into Swiss francs

                               Slide 14-22
         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
   • 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

                                                       Slide 14-23
         Trident Corp:
Swapping Dollars into Swiss francs

                               Slide 14-24
            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
                                                   Slide 14-25
             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

            Sfr301,500            Sfr15,301, 500
PV(Sfr)                  1
                                                 2
                                                       Sfr15,002, 912
             (1 . 020 )              (1 . 020 )

                                                                 Slide 14-26
          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%

             $556,000              $10,556,00 0
PV(US$)                   1
                                                 2
                                                       $ 10 , 011 , 078
              (1 . 055 )             (1 . 055 )

                                                             Slide 14-27
              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
                                  Sfr15,002, 912
 Settlement     $10,011,07 8                      ($ 229 ,818 )
                                   Sfr1.4650/ $

 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
                                                          Slide 14-28
               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

                                                      Slide 14-29
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

                                                    Slide 14-30
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

                                                   Slide 14-31
A Three-way Cross Currency Swap

 C$300                           Province of Ontario                          C$150
 million                               (Canada)                               million
                       $260                               $130
                       million                            million
                                  Borrows $390 million
                                 at US Treasury + 48 bp

   Finish Export Credit                                        Inter-American
           (Finland)                                          Development Bank

    Borrows C$300 million                                     Borrows C$150 million
at Canadian Treasury + 47 bp                              at Canadian Treasury + 44 bp

                                                                            Slide 14-32
 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
   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

                                                      Slide 14-33
 Summary of Learning Objectives
 The primary sources of interest rate risk to an MNE
    are short-term borrowing and investing and long-term
   The techniques and instruments used in interest rate
    risk management resemble those used in currency risk
    management: the old method of lending and
   The primary instruments include forward rate
    agreements (FRAs), interest rate futures, forward
    swaps and interest rate swaps

                                                 Slide 14-34
 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

                                                      Slide 14-35

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