Description
the current swaps and interest rate swaps with the help of examples. It also explains the risks associated with swaps
Currency Swaps
Swaps
A contract where two parties agree to exchange cash flows at future dates according to a prearranged formula It is a portfolio of forward contracts, originate in one day but have different delivery dates Interest rate swaps: I agree to pay you 8% of $10 million each year for the next five years and you agree to pay me whatever one-year LIBOR is (times $10 million) for each of the next five years
Interest Rate Swaps
There are two types of interest rate swaps:
Single currency interest rate swap
“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.
Cross-Currency interest rate swap
This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.
Interest Rate Swap
An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million
Cash Flows to Microsoft
---------Millions of Dollars--------LIBOR FLOATING FIXED Date Mar.5, 2004 Sept. 5, 2004 Mar.5, 2005 Sept. 5, 2005 Mar.5, 2006 Sept. 5, 2006 Mar.5, 2007 Rate 4.2% 4.8% 5.3% 5.5% 5.6% 5.9% 6.4% +2.10 +2.40 +2.65 +2.75 +2.80 +2.95 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –0.40 –0.10 +0.15 +0.25 +0.30 +0.45 Net Cash Flow Cash Flow Cash Flow
Uses of an Interest Rate Swap
Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate
Intel and Microsoft (MS) Transform a Liability
5% 5.2%
Intel
LIBOR
MS
LIBOR+0.1%
Financial Institution is Involved
4.985% 5.2%
5.015%
Intel
LIBOR
F.I.
LIBOR
MS
LIBOR+0.1%
Quotes By a Swap Market Maker
Maturity 2 years 3 years 4 years 5 years 7 years 10 years Bid (%) 6.03 6.21 6.35 6.47 6.65 6.83 Offer (%) 6.06 6.24 6.39 6.51 6.68 6.87 Swap Rate (%) 6.045 6.225 6.370 6.490 6.665 6.850
Interest Rate Swap
Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.S. and wishes to raise $1,00,000 to finance floating-rate loans.
Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.
Interest Rate Swap
Firm B is a BBB-rated Indian company. It needs $100,000 to finance an investment with a five-year economic life.
Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5year floating-rate notes at LIBOR + 0.5 percent. Firm B would prefer to borrow at a fixed rate.
Interest Rate Swap
The borrowing opportunities of the two firms are:
COMPANY
B
BANK A
Fixed rate Floating rate
11.75% LIBOR + .5%
10% LIBOR
Interest Rate Swap
The swap bank makes 0.125%
Swap
10.375%
Bank
10.5% LIBOR – 0.25%
LIBOR –0.125%
Bank A
A saves 0.5%
CO M PAN Y Fixed rate Floating rate 11.75% LIB O R + .5% B
Company
B
B saves 0.5%
BAN K A 10% LIB O R
Currency Swap
Suppose a U.S. MNC wants to finance a £1,00,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.
This will give them exchange rate risk: financing a sterling project with dollars.
They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.
Currency Swap
If they can find a British MNC with a mirrorimage financing need they may both benefit from a swap. If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $1,60,000.
Currency Swap
Consider two firms A and B: firm A is a U.S. based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
Currency Swap
Swap Bank
$8% £11% $8% $9.4% £12%
Firm A
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
Firm B
£12%
Currency Swap
A’s net position is to borrow at £11% A saves £.6% $8%
£11% $8%
Swap Bank
B’s net position is to borrow at $9.4% B saves $.6%
$9.4% £12%
Firm A
Firm
The swap bank makes money too: ?
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
£12%
B
The QSD
The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. In the above example, company B is less creditworthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.
Risks of Swaps
Interest Rate Risk
Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.
Basis Risk
If the floating rates of the two counterparties are not pegged to the same index.
Exchange rate Risk
In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.
Risks of Swaps
Credit Risk
This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.
Mismatch Risk
It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk
The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.
Thank you!!!
doc_843112520.pdf
the current swaps and interest rate swaps with the help of examples. It also explains the risks associated with swaps
Currency Swaps
Swaps
A contract where two parties agree to exchange cash flows at future dates according to a prearranged formula It is a portfolio of forward contracts, originate in one day but have different delivery dates Interest rate swaps: I agree to pay you 8% of $10 million each year for the next five years and you agree to pay me whatever one-year LIBOR is (times $10 million) for each of the next five years
Interest Rate Swaps
There are two types of interest rate swaps:
Single currency interest rate swap
“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.
Cross-Currency interest rate swap
This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.
Interest Rate Swap
An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million
Cash Flows to Microsoft
---------Millions of Dollars--------LIBOR FLOATING FIXED Date Mar.5, 2004 Sept. 5, 2004 Mar.5, 2005 Sept. 5, 2005 Mar.5, 2006 Sept. 5, 2006 Mar.5, 2007 Rate 4.2% 4.8% 5.3% 5.5% 5.6% 5.9% 6.4% +2.10 +2.40 +2.65 +2.75 +2.80 +2.95 –2.50 –2.50 –2.50 –2.50 –2.50 –2.50 –0.40 –0.10 +0.15 +0.25 +0.30 +0.45 Net Cash Flow Cash Flow Cash Flow
Uses of an Interest Rate Swap
Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate
Intel and Microsoft (MS) Transform a Liability
5% 5.2%
Intel
LIBOR
MS
LIBOR+0.1%
Financial Institution is Involved
4.985% 5.2%
5.015%
Intel
LIBOR
F.I.
LIBOR
MS
LIBOR+0.1%
Quotes By a Swap Market Maker
Maturity 2 years 3 years 4 years 5 years 7 years 10 years Bid (%) 6.03 6.21 6.35 6.47 6.65 6.83 Offer (%) 6.06 6.24 6.39 6.51 6.68 6.87 Swap Rate (%) 6.045 6.225 6.370 6.490 6.665 6.850
Interest Rate Swap
Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.S. and wishes to raise $1,00,000 to finance floating-rate loans.
Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.
Interest Rate Swap
Firm B is a BBB-rated Indian company. It needs $100,000 to finance an investment with a five-year economic life.
Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5year floating-rate notes at LIBOR + 0.5 percent. Firm B would prefer to borrow at a fixed rate.
Interest Rate Swap
The borrowing opportunities of the two firms are:
COMPANY
B
BANK A
Fixed rate Floating rate
11.75% LIBOR + .5%
10% LIBOR
Interest Rate Swap
The swap bank makes 0.125%
Swap
10.375%
Bank
10.5% LIBOR – 0.25%
LIBOR –0.125%
Bank A
A saves 0.5%
CO M PAN Y Fixed rate Floating rate 11.75% LIB O R + .5% B
Company
B
B saves 0.5%
BAN K A 10% LIB O R
Currency Swap
Suppose a U.S. MNC wants to finance a £1,00,000 expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.
This will give them exchange rate risk: financing a sterling project with dollars.
They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.
Currency Swap
If they can find a British MNC with a mirrorimage financing need they may both benefit from a swap. If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $1,60,000.
Currency Swap
Consider two firms A and B: firm A is a U.S. based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
Currency Swap
Swap Bank
$8% £11% $8% $9.4% £12%
Firm A
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
Firm B
£12%
Currency Swap
A’s net position is to borrow at £11% A saves £.6% $8%
£11% $8%
Swap Bank
B’s net position is to borrow at $9.4% B saves $.6%
$9.4% £12%
Firm A
Firm
The swap bank makes money too: ?
$ Company A Company B 8.0% 10.0% £ 11.6% 12.0%
£12%
B
The QSD
The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. In the above example, company B is less creditworthy than bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.
Risks of Swaps
Interest Rate Risk
Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.
Basis Risk
If the floating rates of the two counterparties are not pegged to the same index.
Exchange rate Risk
In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.
Risks of Swaps
Credit Risk
This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.
Mismatch Risk
It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk
The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.
Thank you!!!
doc_843112520.pdf