Repurchase Order Repo

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• 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

    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
   • 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”

                             The Short-Term Currency Swap
                 USD loan [BB—>BE]    GBP loan [BB—>BE]

    At time t:   BB transfers USD 100m BE transfers GBP 40m   spot sale of
                 to BE                 to BB                  USD 100m to BE
                                                              at St = USD/GBP 2.5

    At time T: BE transfers USD 103m BB transfers GBP 42m     forward purchase of
               to BB                 to BE                    USD 103m from BE
                                                              at Ft,T = 2.39535

                                                              Total: swap contract

 • 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.

 • Why short-term Swaps exist?

        1. Safety
        2. Reduction of Transaction Costs
        3. Tax Avoidance
        4. Religious objections against interest
        5. Fictitious Transactions

  • Why short-term Swaps exist? (cont.)

 1. Safety:

 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')

  • Why short-term Swaps exist? (cont.)

 2. Reduction of transaction costs:
 If an investor intends to reverse the transaction

        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

  • Why short-term Swaps exist? (cont.)

 3. Tax Avoidance:
 When capital gains are taxed at a lower rate

      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

  • 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

• 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)

  Back-to-back loans: (cont.)

         Flow of initial princ ipals under a back-to-bac k loan

        USD cap mkt                                  USCo


            UKII                                 USCo's SUBS
  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

               The initial flows of principal under a parallel loan

             UKCo's SUBS              USD                  USCo

                UKCo                   GBP             USCo's SUBS
 • 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
 • 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
  • The 1981 IBM/World Bank Currency Swap:(cont.)


  • 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;
  • The 1981 IBM/World Bank Currency Swap:(cont.)
Right of offset between the undertakings

                                   USD s ervic e
              IBM                                          WB
                                 DEM & CHF service

                     DEM & CHF                       USD

             DEM & CHF                               USD Eurobond
             bondholders                                holders

    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.
 • The 1981 IBM/World Bank Currency Swap:(cont.)

                             World/ IBM
                         $                SF       Difference

       IBM           17.59%           7.98%          9.61%

    World Bank       16.58%           8.38%          8.20%

    Difference          1%            0.40%

                     16.70%           8.1%
      Target        (World Bank)      (IBM)
   • 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
  • 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
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
Characteristics of the Modern Currency Swap (cont.)

   The deal is structured as one single contract, with a right of offset


                                  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>
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
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

       (2) PVUSD = + = USD 10m,
       (3) PVDEM = + = DEM 18m
       which implies that the PV in USD is 18m/1.8 = USD 10m
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
      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
•Coupon Swaps (Fixed-for-Floating)

   Characteristics of the Fixed-for-Floating Swap

       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%]
•Coupon Swaps (Fixed-for-Floating)

   Characteristics of the Fixed-for-Floating Swap (cont.)

                      loan            swap contract        total
                      1m at      1m at LIBOR 1m at 16% loan + swap
                   LIBOR + 1%      ("lent")  ("borrowed")

  t: principals        1            <1>          1             1

  interest        <LIBOR + 1%>     LIBOR        16%      <16% + 1%>

  T: principal        <1>            1          <1>          <1>

      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)
• Base Swaps

Example: IN: T-bill rate / OUT: Eurodollar (LIBOR)

     • 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
• Cross-Currency Swaps

                           USD                  USD
                          floating   Bankers   floating             Yamaichi
        Renault                       Trust                         Securities
                            YEN                     YEN
                            fixed                   fixed

            op erat ing
                                                                                 rat e not e
                                                                                 po rt folio

     Renault 's                                                     Yamaichi's
   USD float ing
                                                                     Yen fixed
     rate note
                                                                    rat e lenders
• Cocktail Swap

                            USD 1 2%                        USD 1 2%

                                            Bank B

                          USDLIB +.75 %                     CHF 5 %

          Co A                             Co D                         Co C

            USDLIBOR                              CHF 5 %                   USD 1 2%
              + .7 5%                              fixed                      fixed

       USD flo at in g-                   CHF fix ed-                  USD fix ed-
        rat e lenders                     rate lenders                 rate lenders
• 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

                                        original loan (with the lowest spread)
            most suitable loan:             fixed rate          floating rate

            fixed rate:
                in the same currency:            -          interest rate swap

               in another currency:       fixed-for-fixed      circus swap
                                                              currency swap

                in the same currency: interest rate swap              -

               in another currency:        circus swap      floating-for-floating
                                                               currency swap
• Case. An Interest Rate Swap: Will it work?

       Corporation           Metro Bank               Sushi Bank

    Fixed Rate Payer                                Floating Rate Swap
                             Target Rates
        12% Fixed                                     LIBID (-)1/8%
                            At least 12 basis
B   Fixed Reference Rate:                       B Floating Reference Rate:
a                                               a
s   - 7 year note                               s - Commercial
k   - All in cost 127/8%                        k - Paper rate + 1/2% fee
e                                               e
t    = 12.875%                                  t     93/8 + 1/2% = 97/8%

     Sushi Bank can
       issue 7-yr
    Eurobond at 12%
• Case. An Interest Rate Swap: Will it work? (cont.)

                         LIBOR (overnight)       = 9%
    Basis Swap                     7 days        = 91/8%

     CP + 1/4%                     1 month       = 92/8%

        Vs.                        3 months      = 93/8%

      LIBOR                        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
• Case. An Interest Rate Swap: Will it work? (cont.)

    From Sushi Bank:
    Point of View:

    Sushi receives reference:    11.66% ie 112/3%
                                                       1/3% loss
    Sushi pays:                  LIBOR - 1/2%
                                                    (-) 3/8% gain
    Reference:                   LIBOR - 1/8%

    Total Gain to Sushi Bank:    1/3 - 1/8% = 1/12%
                                 3/8 - 1/3 = (9-8)/24 = 1/24%
• 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

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