Chapter Ten Currency Interest Rate Swaps 10 Chapter objective This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk
INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Second Edition 10 Chapter Ten Currency & Interest Rate Swaps Chapter Objective: This chapter discusses currency and interest rate swaps, which are relatively new instruments for hedging long-term interest rate risk and foreign exchange risk
Chapter Outline Types of Swaps ●SlZe of the Swap Market The swap bank ● Interest Rate Swaps ● Currency swaps McGraw-Hilylrwoin 10-1 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-1 Chapter Outline ⚫ Types of Swaps ⚫ Size of the Swap Market ⚫ The Swap Bank ⚫ Interest Rate Swaps ⚫ Currency Swaps
Chapter Outline(continued) Swap Market Quotations o Variations of Basic Currency and Interest rate Swaps o Risks of Interest rate and currency Swaps Swap Market Efficiency o Concluding points about swaps McGraw-Hilylrwoin 10-2 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-2 Chapter Outline (continued) ⚫ Swap Market Quotations ⚫ Variations of Basic Currency and Interest Rate Swaps ⚫ Risks of Interest Rate and Currency Swaps ⚫ Swap Market Efficiency ⚫ Concluding Points About Swaps
Definitions In a swap two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals 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 McGraw-Hilylrwoin 10-3 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-3 Definitions ⚫ In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. ⚫ 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
Size of the Swap Market o In 1995 the notational principal of interest rate swaps was $12, 810, 736.000,000 Currency swaps $1, 197, 395,000,000 The most popular currencies are U.Ss(34%) ￥(23%) DM(11% FF(10%) ￡(6%) McGraw-Hilylrwoin 10-4 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-4 Size of the Swap Market ⚫ In 1995 the notational principal of: interest rate swaps was $12,810,736,000,000. Currency swaps $1,197,395,000,000 ⚫ The most popular currencies are: ◼ U.S.$ (34%) ◼ ¥ (23%) ◼ DM (11%) ◼ FF (10%) ◼ £ (6%)
The Swap Bank a swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties o The swap bank can serve as either a broker or a de ealer 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 McGraw-Hilylrwoin 10-5 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-5 The Swap Bank ⚫ 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
An Example of an 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. K. who wishes to raise s10000-000 to finance floating-rate Eurodollar loans Bank a is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent It would make more sense to for the bank to issue floating-rate notes at liBor to finance floating-rate Eurodollar loans McGraw-Hilylrwoin 10-6 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-6 An Example of an 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.K. who wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. ◼ Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. ◼ It would make more sense to for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans
An Example of an Interest Rate Swap o Firm B is a BBB-rated U.s. company. It needs S10.000000 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 5 year FRNs at liBor 2 percent Firm b would prefer to borrow at a fixed rate McGraw-Hilylrwoin 10-7 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-7 An Example of an Interest Rate Swap ⚫ Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a fiveyear 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 5- year FRNs at LIBOR + ½ percent. ◼ Firm B would prefer to borrow at a fixed rate
An Example of an Interest Rate Swap The borrowing opportunities of the two firms are shown in the following table COMPANYB BANK A DIFFERENTIAL Fixed rate 1175% 10% 1.75% Floating rate LIBOR +.5% IBOR 5% OSD 125% McGraw-Hilylrwoin 10-8 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-8 An Example of an Interest Rate Swap The borrowing opportunities of the two firms are shown in the following table: COMPANY B BANK A DIFFERENTIAL Fixed rate 11.75% 10% 1.75% Floating rate LIBOR + .5% LIBOR .5% QSD = 1.25%
An Example of an Interest Rate Swap Swap The swap bank makes this offer to bank You Bank 103/8% pay LIBOr-1/8%per year on $10 million for 5 LIBOR-1/8% years and we will pay Bank ou103/8%on$10 A million for 5 years COMPANY B BANK A DIFFERENTIAL Fixed rate 11.75% 10 1.75% Floating rate LIBOR +.5% LIBOR OSD McGraw-Hilylrwoin 10-9 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 10-9 10 3/8% LIBOR – 1/8% An Example of an Interest Rate Swap Bank A Swap Bank 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 BANK A DIFFERENTIAL Fixed rate 11.75% 10% 1.75% Floating rate LIBOR + .5% LIBOR .5% QSD = 1.25%