Description
The objective of the ppt is to explain why MNCs consider long-term financing in foreign currencies.
Long Term Debt Financing
Group 2
Chapter Objectives
• To explain why MNCs consider long-term financing in foreign currencies • To explain how the feasibility of long-term financing in foreign currencies can be assessed • To explain how the assessment of long-term financing in foreign currencies can be adjusted for bonds with floating interest rates
The Long-Term Financing Decision
• Because bonds denominated in foreign currencies sometimes require lower yields, MNCs often consider long-term financing in foreign currencies • The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan • From an interest rate angle, decreasing interest rates are favorable • From an exchange rate angle, a depreciating local currency is favorable
Annualized Bond Yields Across Countries
Ten-year maturity, as of August 2009
35 30
Annualized Bond Yield
25 20
Brazilian real Australian dollar Indian rupee
15 10 5 0
German mark
¥
US$
£
The Long-Term Financing Decision (contd.)
• To make the long-term financing decision, the MNC must
? determine the amount of funds needed ? forecast the price (interest rate) at which the bond may be issued ? forecast the exchange rates of the borrowed currency for the times when it
has to make payments (coupons and principal) to the bondholders
• Then the probability distribution of the bond’s financing costs may be determined.
Actual Costs of Financing
With Pound-Denominated Bonds from a U.S. Perspective
Exchange Rate of £ US$ Needed to Cover Annual Coupon Payment of £1 million
3.0 2.5 2.0 1.5 1.0 0.5 0.0 1975
3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 1980 1985 1990 1995 2000
Use of Yield Curves to Make Debt Maturity Decisions
• An MNC must decide on the maturity for any potential debt. To do this, the MNC may want to assess the yield curve in the country of the currency to be borrowed • Since the slopes of the yield curves may vary across countries, the choice of short-term, medium-term, or long-term debt financing may vary across countries too
Yield Curves Across Countries
As of February 2001
6.0
Annualized Yield (except Japan)
2.5
Japan
Annualized Yield (Japan only)
5.6 5.2
Canada
2.0 1.5
Italy Germany
4.8
U.S.
1.0 0.5 0.0
4.4 4.0 0 5 10 15 20
U.K.
25
30
Years to Maturity
(I) Exchange Rate Risk
Managing Exchange Rate Risk
• Point-estimate exchange rate forecasts cannot adequately account for the potential impact of exchange rate fluctuations • Instead, the probability distribution of the exchange rate should be developed, so as to determine the expected financing cost and its probability distribution • Computer simulation may aid the process • The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:
1. 2. 3. 4. 5.
Offsetting cash inflows in the borrowed currency Forward contracts Currency swaps Parallel (or back-to-back) loans Currency Diversification
1) Offsetting cash inflows in the borrowed currency
• Making inflow payments or income offset outflow payment relating to bond financing • Extent of exchange rate risk is eliminated up to the amount of matching cash flows • However, matching the timing and amount of outflows and inflows is difficult • Example – Nike issues bonds dominated in yen at low interest rates and uses yen-dominated revenue to make the interest payments
2) Forward Contracts
• The firm can issue bonds denominated in local currency and simultaneously hedge itself through the forward market • It can purchase foreign currency forwards each time payments are required • However, the forward rate is likely to be greater than the spot rate to achieve interest parity, which would make hedging a costly option
3) Currency Swaps
• In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals • In this case the cash flows exchanged are in different currencies • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties • The swap bank can serve as either a broker or a dealer – As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap – As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty
Example 1 - Currency Swaps
Euros Received From Ongoing Operations
Euro Payments Euro Payments Miller Company [known within the dollardenominated market] Dollar Payments Beck Company [known within the eurodenominated market] Euro Payments
Dollars Received From Ongoing Operations
Dollar Payments
Dollar Payments
Investors in Dollardenominated Bonds Issued by Miller
Investors in Eurodenominated Bonds Issued by Beck
Example 2 - Currency Swaps
Swap Bank $8% £11% $8% Company A £12% Company B £12% $9.4%
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
Example 2 - Currency Swaps
Swap Bank $8% £11% £12% Company B A’s net position is to borrow at £11% A saves £.6% £12% $9.4%
$8%
Company A
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
Example 2 - Currency Swaps
Swap
Bank
$8% £11% $8% £12% Company B B’s net position is to borrow at $9.4% $9.4%
Company A
£12%
B saves $.6%
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
Example 2 - Currency Swaps
The swap bank makes money too: Swap Bank 1.4% of $16 million financed with 1% of £10 million per year for 5 years. $9.4% £12% Company £12%
$8% £11%
$8% Company A
At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.
B
The swap bank faces exchange rate risk, but maybe they can lay it off in another swap.
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
4) Parallel Loans
Two parties provide simultaneous loans with an agreement to repay at a specified point in the future
? U.S. Parent
Provision of loans
British Parent
Subsidiary of U.S.- based MNC that is located in the U.K.
? Repayment of loans in the currency that was borrowed
Subsidiary of U.K.- based MNC that is located in the U.S.
5) Currency Diversification
• A firm can dominate bonds in several foreign currencies where lower yields are possible, rather than a single foreign currency, so that substantial exchange rate volatility does not drastically affect bond payments • Choose currencies whose movements are not significantly correlated with each other • The firm can also develop currency cocktail bonds, that are denominated in not one, but a mixture (or cocktail) of currencies
(II) Interest Rate Risk
Floating-Rate Bonds
• Bond coupon rates can be either fixed or floating • Eurobonds are often issued with a floating coupon rate. For example, the rate may be tied to the London Interbank Offer Rate (LIBOR) • If the coupon rate is floating, forecasts are required for both exchange rates and interest rates • When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk • Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. They are used by bond issuers to reconfigure future bond payments to a more preferable structure
Interest Rate Swaps
• The notional principal outstanding of interest rate swaps in 2008 was $40 trillion • Swaps are off-the-book transactions and have become an important source of revenue and risk for banks • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties • The swap bank can serve as either a broker or a dealer
– As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap – As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty
Example 1 - Interest Rate Swaps
In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals The following companies can issue debt at the following rates:
Company
Quality Risky
Fixed Rate
9% 10.5%
Floating Rate
LIBOR + 50bps LIBOR + 100bps
• Quality issues fixed rate bonds at 9% • Risky issues floating rate bonds at LIBOR + 10.5% • They enter into a swap contract to reduce interest rate risk, as well as reduce the cost of financing
Example 1 - Interest Rate Swaps
Quality Company Choice of 9% fixed or LIBOR + .5% Prefers variable Variable Rate Payments at LIBOR+.5% Risky Company Choice of 10.5% fixed or LIBOR + 1% Prefers fixed
Fixed Rate Payments at 9%
Fixed Rate Payments at 9.5%
Variable Rate Payments at LIBOR+1%
Investors in Fixed Rate Bonds Issued by Quality Company
Investors in Variable Rate Bonds Issued by Risky Company
Gains ½ %
Saves ½ %
Example 2 - Interest Rate Swaps
The borrowing opportunities of the two firms are shown in the following table:
COMPANY B
BANK A
DIFFERENTIAL
Fixed rate Floating rate
11.75% LIBOR + .5%
10% LIBOR QSD =
1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
Swap Bank 10 3/8% LIBOR – 1/8% Bank A The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. 10 3/8%
Swap Bank Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.
LIBOR – 1/8% Bank 10% A
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
The swap bank makes this offer to company B: You pay us 10 ½ % per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼% Company B
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
Here’s what’s in it for B:
Swap Bank
½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. 10 ½%
They can borrow externally at LIBOR + ½ % and LIBOR – ¼% have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap. Company B LIBOR + ½%
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
The swap bank makes money too. 10 3/8 % LIBOR – 1/8% Bank 10% A Swap Bank ¼ % of $10 million = $25,000 per year for 5 years. 10 ½% LIBOR – ¼% Company B LIBOR + ½%
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8
A saves ½ %
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5% BANK A 10% LIBOR QSD =
¼
DIFFERENTIAL 1.75% .5% 1.25%
B saves ½ %
Example 2 - Interest Rate Swaps
The swap bank makes ¼% 10 3/8 % LIBOR – 1/8% Bank 10% A Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD
Swap
Bank 10 ½% LIBOR – ¼% Company B LIBOR + ½%
A saves ½ %
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5% BANK A 10% LIBOR QSD = DIFFERENTIAL 1.75% .5% 1.25%
B saves ½ %
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 credit-worthy 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 Interest Rate and Currency 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 Interest Rate and Currency Swaps (continued)
• 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_929500252.ppt
The objective of the ppt is to explain why MNCs consider long-term financing in foreign currencies.
Long Term Debt Financing
Group 2
Chapter Objectives
• To explain why MNCs consider long-term financing in foreign currencies • To explain how the feasibility of long-term financing in foreign currencies can be assessed • To explain how the assessment of long-term financing in foreign currencies can be adjusted for bonds with floating interest rates
The Long-Term Financing Decision
• Because bonds denominated in foreign currencies sometimes require lower yields, MNCs often consider long-term financing in foreign currencies • The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan • From an interest rate angle, decreasing interest rates are favorable • From an exchange rate angle, a depreciating local currency is favorable
Annualized Bond Yields Across Countries
Ten-year maturity, as of August 2009
35 30
Annualized Bond Yield
25 20
Brazilian real Australian dollar Indian rupee
15 10 5 0
German mark
¥
US$
£
The Long-Term Financing Decision (contd.)
• To make the long-term financing decision, the MNC must
? determine the amount of funds needed ? forecast the price (interest rate) at which the bond may be issued ? forecast the exchange rates of the borrowed currency for the times when it
has to make payments (coupons and principal) to the bondholders
• Then the probability distribution of the bond’s financing costs may be determined.
Actual Costs of Financing
With Pound-Denominated Bonds from a U.S. Perspective
Exchange Rate of £ US$ Needed to Cover Annual Coupon Payment of £1 million
3.0 2.5 2.0 1.5 1.0 0.5 0.0 1975
3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 1980 1985 1990 1995 2000
Use of Yield Curves to Make Debt Maturity Decisions
• An MNC must decide on the maturity for any potential debt. To do this, the MNC may want to assess the yield curve in the country of the currency to be borrowed • Since the slopes of the yield curves may vary across countries, the choice of short-term, medium-term, or long-term debt financing may vary across countries too
Yield Curves Across Countries
As of February 2001
6.0
Annualized Yield (except Japan)
2.5
Japan
Annualized Yield (Japan only)
5.6 5.2
Canada
2.0 1.5
Italy Germany
4.8
U.S.
1.0 0.5 0.0
4.4 4.0 0 5 10 15 20
U.K.
25
30
Years to Maturity
(I) Exchange Rate Risk
Managing Exchange Rate Risk
• Point-estimate exchange rate forecasts cannot adequately account for the potential impact of exchange rate fluctuations • Instead, the probability distribution of the exchange rate should be developed, so as to determine the expected financing cost and its probability distribution • Computer simulation may aid the process • The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:
1. 2. 3. 4. 5.
Offsetting cash inflows in the borrowed currency Forward contracts Currency swaps Parallel (or back-to-back) loans Currency Diversification
1) Offsetting cash inflows in the borrowed currency
• Making inflow payments or income offset outflow payment relating to bond financing • Extent of exchange rate risk is eliminated up to the amount of matching cash flows • However, matching the timing and amount of outflows and inflows is difficult • Example – Nike issues bonds dominated in yen at low interest rates and uses yen-dominated revenue to make the interest payments
2) Forward Contracts
• The firm can issue bonds denominated in local currency and simultaneously hedge itself through the forward market • It can purchase foreign currency forwards each time payments are required • However, the forward rate is likely to be greater than the spot rate to achieve interest parity, which would make hedging a costly option
3) Currency Swaps
• In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals • In this case the cash flows exchanged are in different currencies • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties • The swap bank can serve as either a broker or a dealer – As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap – As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty
Example 1 - Currency Swaps
Euros Received From Ongoing Operations
Euro Payments Euro Payments Miller Company [known within the dollardenominated market] Dollar Payments Beck Company [known within the eurodenominated market] Euro Payments
Dollars Received From Ongoing Operations
Dollar Payments
Dollar Payments
Investors in Dollardenominated Bonds Issued by Miller
Investors in Eurodenominated Bonds Issued by Beck
Example 2 - Currency Swaps
Swap Bank $8% £11% $8% Company A £12% Company B £12% $9.4%
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
Example 2 - Currency Swaps
Swap Bank $8% £11% £12% Company B A’s net position is to borrow at £11% A saves £.6% £12% $9.4%
$8%
Company A
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
Example 2 - Currency Swaps
Swap
Bank
$8% £11% $8% £12% Company B B’s net position is to borrow at $9.4% $9.4%
Company A
£12%
B saves $.6%
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
Example 2 - Currency Swaps
The swap bank makes money too: Swap Bank 1.4% of $16 million financed with 1% of £10 million per year for 5 years. $9.4% £12% Company £12%
$8% £11%
$8% Company A
At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.
B
The swap bank faces exchange rate risk, but maybe they can lay it off in another swap.
$ Company A Company B 8.0%
£ 11.6%
10.0% 12.0%
4) Parallel Loans
Two parties provide simultaneous loans with an agreement to repay at a specified point in the future
? U.S. Parent
Provision of loans
British Parent
Subsidiary of U.S.- based MNC that is located in the U.K.
? Repayment of loans in the currency that was borrowed
Subsidiary of U.K.- based MNC that is located in the U.S.
5) Currency Diversification
• A firm can dominate bonds in several foreign currencies where lower yields are possible, rather than a single foreign currency, so that substantial exchange rate volatility does not drastically affect bond payments • Choose currencies whose movements are not significantly correlated with each other • The firm can also develop currency cocktail bonds, that are denominated in not one, but a mixture (or cocktail) of currencies
(II) Interest Rate Risk
Floating-Rate Bonds
• Bond coupon rates can be either fixed or floating • Eurobonds are often issued with a floating coupon rate. For example, the rate may be tied to the London Interbank Offer Rate (LIBOR) • If the coupon rate is floating, forecasts are required for both exchange rates and interest rates • When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk • Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. They are used by bond issuers to reconfigure future bond payments to a more preferable structure
Interest Rate Swaps
• The notional principal outstanding of interest rate swaps in 2008 was $40 trillion • Swaps are off-the-book transactions and have become an important source of revenue and risk for banks • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties • The swap bank can serve as either a broker or a dealer
– As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap – As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty
Example 1 - Interest Rate Swaps
In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals The following companies can issue debt at the following rates:
Company
Quality Risky
Fixed Rate
9% 10.5%
Floating Rate
LIBOR + 50bps LIBOR + 100bps
• Quality issues fixed rate bonds at 9% • Risky issues floating rate bonds at LIBOR + 10.5% • They enter into a swap contract to reduce interest rate risk, as well as reduce the cost of financing
Example 1 - Interest Rate Swaps
Quality Company Choice of 9% fixed or LIBOR + .5% Prefers variable Variable Rate Payments at LIBOR+.5% Risky Company Choice of 10.5% fixed or LIBOR + 1% Prefers fixed
Fixed Rate Payments at 9%
Fixed Rate Payments at 9.5%
Variable Rate Payments at LIBOR+1%
Investors in Fixed Rate Bonds Issued by Quality Company
Investors in Variable Rate Bonds Issued by Risky Company
Gains ½ %
Saves ½ %
Example 2 - Interest Rate Swaps
The borrowing opportunities of the two firms are shown in the following table:
COMPANY B
BANK A
DIFFERENTIAL
Fixed rate Floating rate
11.75% LIBOR + .5%
10% LIBOR QSD =
1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
Swap Bank 10 3/8% LIBOR – 1/8% Bank A The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
½ % of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. 10 3/8%
Swap Bank Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.
LIBOR – 1/8% Bank 10% A
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
The swap bank makes this offer to company B: You pay us 10 ½ % per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼% Company B
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
Here’s what’s in it for B:
Swap Bank
½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. 10 ½%
They can borrow externally at LIBOR + ½ % and LIBOR – ¼% have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½ % better than they can borrow floating without a swap. Company B LIBOR + ½%
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5%
BANK A 10% LIBOR QSD =
DIFFERENTIAL 1.75% .5% 1.25%
Example 2 - Interest Rate Swaps
The swap bank makes money too. 10 3/8 % LIBOR – 1/8% Bank 10% A Swap Bank ¼ % of $10 million = $25,000 per year for 5 years. 10 ½% LIBOR – ¼% Company B LIBOR + ½%
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8
A saves ½ %
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5% BANK A 10% LIBOR QSD =
¼
DIFFERENTIAL 1.75% .5% 1.25%
B saves ½ %
Example 2 - Interest Rate Swaps
The swap bank makes ¼% 10 3/8 % LIBOR – 1/8% Bank 10% A Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD
Swap
Bank 10 ½% LIBOR – ¼% Company B LIBOR + ½%
A saves ½ %
COMPANY B Fixed rate Floating rate 11.75% LIBOR + .5% BANK A 10% LIBOR QSD = DIFFERENTIAL 1.75% .5% 1.25%
B saves ½ %
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 credit-worthy 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 Interest Rate and Currency 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 Interest Rate and Currency Swaps (continued)
• 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_929500252.ppt