Slide.

2ème année de la Grande Ecole de l’Institut de Rabat

Semestre 3

Monetary and Financial Economics

Interest Rate and Currency Swaps

1st Term 2017-2018

Slide.2

Plan for today

• Swaps Background
• Participation by Financial Institutions
• Plain Vanilla Swaps
• Other Types of Interest Rate Swaps
• Risks of Interest Rate Swaps
• Pricing Interest Rate Swaps
• Factors Affecting the Performance of Interest Rate Swaps
• Currency Swaps
• Globalization of Swap Markets

Monetary and Financial Economics

Slide.3

Swaps Background
• An interest rate swap is an arrangement whereby one party exchanges
one set of interest payments for another
– e.g., fixed-rate payments are exchanged for floating-rate payments
• The provisions of a swap include:
– The notional principal
– The fixed interest rate
– The formula and type of index to determine the floating rate
– The frequency of payments
– The lifetime of the swap
• Amounts owed are typically netted out so that only the net payment is
made
• The market for swaps is facilitated by over-the-counter trading
– Swaps are less standardized than other derivatives

Monetary and Financial Economics

 Slide.4

Swaps Background
• Swaps became popular in the early 1980s because of large fluctuations in
interest rates
– e.g., financial institutions traditionally had more interest rate-sensitive
liabilities than assets and were adversely affected by rising interest rates
– e.g., some foreign financial institutions had access to long-term fixed rate
funding but used funds primarily for floating rate loans
– By engaging in an interest rate swap, both institutions can reduce their
exposure to interest rate risk
• A U.S. financial institutions could send fixed-rate payments to a European
financial institution in exchange for floating-rate payments
– If interest rates rise, the U.S. financial institution receives higher interest
payments from the floating-rate portion, which helps to offset the rising
cost of obtaining deposits
– If interest rates decline, the European institution provides lower interest
payments in the swap, which helps to offset the lower interest payments
received on its floating-rate loans
– The U.S. institution forgoes the potential benefits from a decline in
interest rates
– The European institution forgoes the potential benefits from an increase
in interest rates
Monetary and Financial Economics
Slide.5

Swaps Background
• A primary reason for the popularity of swaps is market imperfections
– A lack of information about foreign institutions and convenience
encourages individual depositors to place deposits locally
• Swaps are sometimes used for speculative purposes
– e.g., a firm could engage in a swap to benefit from rising interest
rates even if its operations are not exposed to interest rate
movements

Monetary and Financial Economics

Slide.6

Participation by Financial Institutions

• Financial institutions that are exposed to interest rate movements
commonly engage in swaps to reduce interest rate risk
• Some commercial banks and securities firms serve as intermediaries
by matching up firms and facilitating the swap arrangements
– Charge fees and may provide credit guarantees
• Some institutions act as dealers in swaps
– The financial institution takes the counterparty position in order
to serve a client

Monetary and Financial Economics

Slide.7

Participation by Financial Institutions

Financial Institution Participation in Swap Market

Commercial banks ØEngage in swaps to reduce interest rate risk
ØServe as an intermediary by matching up two parties in a
swap
ØServe as a dealer by taking the counterparty position to
accommodate a party the desires to engage in a swap
Finance companies ØEngage in swaps to reduce interest rate risk
Securities firms ØServe as an intermediary by matching up two parties in a
swap
ØServe as a dealer by taking the counterparty position to
accommodate a party that desires to engage in a swap
Insurance companies ØEngage in swaps to reduce interest rate risk
Pension funds ØEngage in swaps to reduce interest rate risk
Hedge funds ØEngage in swaps to speculate on interest rate movements
and/or hedge existing exposures

Monetary and Financial Economics

Slide.8

Plain Vanilla Swaps

• In a plain vanilla swap (fixed-for-floating swap), fixed-rate
payments are periodically exchanged for floating-rate payments
• Consider two scenarios:
– A consistent rise in market interest rates
– A consistent decline in market interest rates

Monetary and Financial Economics

Slide.9

Plain Vanilla Swaps

Rising Interest Rates Declining Interest Rates

Level of
Interest Payments Floating Inflow
Payments

Fixed Outflow Fixed Outflow

Payments Payments

Floating Inflow
Payments

End of Year

Monetary and Financial Economics

Slide.10

Using A Plain Vanilla Swap

Sofia Bank has negotiated a plain vanilla swap in which it will
exchange (pay to the counterparty) fixed payments of 8% for (to
receive from the counterparty) floating payments equal to LIBOR
plus 1% at the end of each of the next four years. Assume that the
notional principal is $100 million.
1. Does Sofia Bank expecting a decrease or an increase of interest
rate?
2. Fill in the table on the next slide for the two scenarios of rising and
falling interest rates.
Slide.11

Scenario 1 – Increasing Int. Rates Year

1 2 3 4
LIBOR 7.0% 7.5% 8.5% 9.5%
Floating rate received
Fixed rate paid
Swap differential
Net dollar amount received by Sofia Bank
Scenario 2 – Decreasing Int. Rates Year

1 2 3 4
LIBOR 6.5% 6.0% 5.0% 4.5%
Floating rate received
Fixed rate paid
Swap differential
Net dollar amount received by Sofia Bank
Slide.12

Scenario 1 -- Increasing Year

Int. Rates
1 2 3 4
LIBOR 7.0% 7.5% 8.5% 9.5%
Floating rate received 8.0% 8.5% 9.5% 10.5%
Fixed rate paid 8.0% 8.0% 8.0% 8.0%
Swap differential 0.0% 0.5% 1.5% 2.5%
Net dollar amount received $0 $500K $1.5M $2.5M
Scenario 2 – Decreasing Year
Int. Rates
1 2 3 4
LIBOR 6.5% 6.0% 5.0% 4.5%
Floating rate received 7.5% 7.0% 6.0% 5.5%
Fixed rate paid 8.0% 8.0% 8.0% 8.0%
Swap differential –0.5% –1.0% –2.0% –2.5%
Net dollar amount received –$500K –$1M –$2M –$2.5M
Slide.13

Forward Swaps
• A forward swap involves an exchange of interest payments that
does not begin until a specified future point in time
– Useful for institutions that expect to be exposed to interest rate
risk at a future point in time
– The fixed rate on a forward swap may differ from the fixed rate
on a swap beginning immediately
• Institutions may be able to negotiate a fixed rate today that is
less than the expected fixed rate on a swap negotiated in the
future
Slide.14

Callable Swaps
• A callable swap provides the party making the fixed payments with
the right to terminate the swap prior to its maturity
– Allows the fixed-rate payer to avoid exchanging future interest
payments if it desires
• The fixed-rate payer pays a premium in the form of a higher interest
rate than without the call feature
• Callable swaps are an example of swaptions
Slide.15

Putable Swaps

• A putable swap provides the party making the floating-rate

payments with a right to terminate the swap
– The floating-rate payer pays a premium in the form of a higher
floating rate
• Extendable swaps
– An extendable swap contains a feature that allows the fixed-for-
floating party to extend the swap period
– The terms of an extendable swap reflect a price paid for the
extendability feature
Slide.16

Zero-Coupon-for-Floating Swaps

• In a zero-coupon-for-floating swap:
– The fixed-rate payer makes a single payment at the maturity date
– The floating-rate payer makes periodic payments throughout the
swap period
• An institution that expects interest rates to increase would prefer to
be the fixed-rate payer
• An institution that expects interest rates to decline would prefer to be
the floating-rate payer
Slide.17

Rate Capped & Equity Swaps

• Rate-capped swaps
– A rate-capped swap involves the exchange of fixed-rate
payments for floating-rate payments that are capped
– The floating-rate payer pays an up-front fee for this feature
– The fixed-rate payer may allow the cap if it believes interest rates
will not exceed the cap and receives the up-front fee
• Equity swaps
– An equity swap involves the exchange of interest payments
linked to the degree of change in a stock index
– Appropriate for portfolio managers of insurance companies or
pension funds that are managing stocks and bonds
 Slide.18

Rate-Capped Swap

Rising Interest Rates Declining Interest Rates

Level of
Interest Payments

Floating Inflow
Cap level
Payments
Fixed Outflow
Payments
Fixed Outflow
Payments
Floating Inflow
Payments

End of Year
Slide.19

Other Types of Interest Rate Swaps

• Use of swaps to accommodate financing preferences
• Some swaps are combined with other transactions such as the
issuance of bonds
– Corporate borrowers may be able to get a more attractive
rate when using floating-rate debt
– Other corporate borrowers may prefer to borrow at a
floating-rate but find it advantageous to borrow at a fixed
rate
• Financial intermediaries may match up participants and
sometimes assume the default risk involved
Slide.20

Other Types of Interest Rate Swaps

• Tax advantage swaps

– Firms with expiring tax loss carryforwards from previous years
can engage in a swap that calls for receipt of a large up-front
payment with less favorable terms over time
• Firms would realize an immediate gain and possible losses in
future years
– Firms expecting large future losses but large gains this year could
engage in a swap requiring a large payment now and more
favorable terms over time
Slide.21

Factors Affecting the Performance of Interest Rate Swaps

• The most important factors are forces that influence interest rate
movements
• The impact of the underlying forces depends on the party’s swap
position
– e.g., strong economic growth can increase rates, which is
beneficial for a party that is swapping fixed-rate payments for
floating-rate payments but not for the counterparty
• Indicators monitored by participants in the swap market
– Economic growth indicators
– Inflation indicators
– Indicators of government borrowing
Slide.22

Risks of Interest Rate Swaps

• Basis risk is the risk that the interest rate of the index used for an
interest rate swap will not move perfectly in tandem with the
floating-rate instruments of the parties involved in the swap
• Default risk is the risk that a firm involved in the swap will not meet
its payment obligations
– Usually not pronounced because the nondefaulting party will
discontinue its payments
• Sovereign risk reflects potential adverse effects resulting from a
country’s political conditions
– e.g., the government may take over one of the parties of the swap
Slide.23

Currency Swaps
• Currency swaps
– A currency swap is an arrangement whereby currencies are
exchanged at specified exchange rates and at specified intervals
• A combination of currency futures contracts
For example:
• To convert a liability in one currency into a liability in another currency.
• Financially similar to (but legally different from) two parallel loans.
• To convert an investment (asset) in one currency to an investment in
another currency.
• Currency swaps are commonly used by firms to hedge their exposure to
exchange rate fluctuations
• Some currency swaps allow for early termination
• Using currency swaps to hedge bond payments
• Currency swaps can be used in conjunction with bond issues to hedge
foreign cash flows
 Currency Swaps
Slide.24

• There are four types of basic currency swaps:

– fixed for fixed.
– fixed for floating.
– floating for fixed.
– floating for floating.
• N.B.: It is the interest rates that are fixed or floating.
• Unlike an interest rate swap, the Notional Principal is exchanged at
the swap’s initiation and termination dates.
Slide.25

Currency Swaps
• Most often used when companies make cross-border capital
investments or projects.
– Ex., U.S. parent company wants to finance a project undertaken
by its subsidiary in Europe. Project proceeds would be used to
pay interest and principal.
– Options:
1. Borrow US$ and convert to Euro – exposes company to
exchange rate risk.
2. Borrow in Europe– rate available may not be as good as that in
the U.S. if the subsidiary is relatively unknown.
3. Find a counterparty and set up a currency swap.
Slide.26

Currency Swaps

• Typically, a company should have a comparative

advantage in borrowing locally

Swap
pay foreign
Pay foreign Bank
issue local issue local

Company Receive Receive Company

A local local B

Issue local Issue local

Slide.27

An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a €40,000,000 expansion of a

German plant.
• They could borrow dollars in the U.S. where they are well known
and exchange for dollars for euros.
– This will give them exchange rate risk: financing a euro project
with dollars.
• They could borrow euro in the international bond market, but pay a
premium since they are not as well known abroad.
• If they can find a German MNC with a mirror-image financing need
they may both benefit from a swap.
• If the spot exchange rate is S0($/ €) = $1.30/ €, the U.S. firm needs
to find a German firm wanting to finance dollar borrowing in the
amount of $52,000,000.

27
Slide.28

An Example of a Currency Swap

• Consider two firms A and B: firm A is a U.S.–based multinational and
firm B is a Germany–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 8.0% 7.0%
Company B 9.0% 6.0%

28
Slide.29

An Example of a Currency Swap

Annual
Interest Annual
$4.16M
Swap Interest
$4.16M
$8%
Bank $8%

€ 6% € 6%
$8% Firm Annual Annual Firm € 6%
Interest Interest
Borrow A €2.4 M €2.4 M B Borrow
$52M € 40M

$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%

29
Slide.30

An Example of a Currency Swap

A’s net position is to Swap B’s net position is

borrow at € 6% to borrow at $8%
Bank
$8% $8%

€ 6% € 6%
$8% Firm Firm € 6%

A B
$52M € 40M

$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
Slide.31

Swap Market Quotations

• Swap banks will tailor the terms of interest rate and currency swaps to
customers’ needs. They also make a market in “plain vanilla” and
currency swaps and provide quotes for these. Since the swap banks are
dealers for these swaps, there is a bid-ask spread.
• Interest Rate Swap Example:
• Swap bank terms: USD: 2.50 – 2.65
Means that the bank is willing to pay fixed-rate 2.50% interest against
receiving LIBOR OR bank is willing to receive fixed-rate 2.65%
against paying LIBOR.
• Currency Swap Example:
• Swap bank terms: USD 2.50 – 2.65
Euro 3.25 – 3.50
Means that bank is willing to make fixed rate USD payments at 2.5% in
return for receiving fixed rate Euro at 3.5% OR the bank is willing to
receive fixed-rate USD at 2.65% in return for making fixed-rate Euro
payments at 3.25%
31
Slide.32

Currency Swaps
Simple Example:
• After raising the $10 million in floating rate financing and swapping
into fixed rate payments, Trident decides it would prefer to make its
debt-service payments in Swiss francs
– Trident signed a 3-year contract with a Swiss buyer, thus providing
a stream of cash flows in Swiss francs
• Trident would now enter into a three-year pay Swiss francs and receive
US dollars currency swap
– Both interest rates are fixed
– Trident will pay 2.01% (ask rate) fixed SF interest and receive
5.56% (bid rate) fixed US dollars
• Spot rate on date of agreement establishes notional principal is in
target currency (1$=1.5 SF)
– Notional amount of SF 15,000,000.
– Commit to payments SF 301,500 (2.01% ´ SF15,000,000)
– Unlike an interest rate swap, The notional amounts part of swap
agreement.
Slide.33

Swap Market Quotations

Source: Financial Times (as quoted by CME)

Slide.34

Currency Swaps
Slide.35

Unwinding the currency Swaps

• As with the original loan agreement, a swap can be entered or
unwound if viewpoints change or other developments occur
• Assume that the 3-year contract with the Swiss buyer terminates
after one year, Trident no longer needs the currency swap.
• How to unwind it?
– Discount remaining cash flows under swap agreement at current
interest rates.
• The current 2 year fixed rate for Sfr is now 2.00%
• The current 2 year fixed dollar rate is now 5.50%

– Convert target currency back to home currency

• The current spot SF 1.465/$
– Determine whether Trident gain or loose in this unwinding?
Slide.36

Unwinding the currency Swaps

• PV swap commitment (outflows) 301,500 15,301,500
+ = SF15,002,912
1 2
(1.020) (1.020)
• PV of remaining cash flows on the $-side of swap (inflows):

$556,000 $10,556,000
PV(US$) = 1
+ 2
= $10,011,078
(1.055) (1.055)

• If current spot SF 1.465/$ net settlement

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 unwinding due to Swiss franc
appreciation.
Slide.37

Currency Swaps

• Risks of currency swaps

– Basis risk can exist if the firm cannot obtain a currency swap on
the currency it is exposed to and uses a related currency instead
– Credit risk reflects the possibility that the counterparty may
default on its obligation
– Sovereign risk reflects the possibility that a county may restrict
the convertibility of a particular currency
Slide.38

Pricing Interest Rate Swaps

• Prevailing market interest rates
– The fixed rate in the swap is influenced by supply and demand
conditions for funds
– Generally, the interest rates of the swap reflect the prevailing
interest rates at the time of the agreement
• Availability of counterparties
– When many counterparties are available, a more attractive deal
might be negotiated
– Availability of counterparties can change in response to economic
conditions
• Credit and sovereign risk
– e.g., a firm that desires a fixed-for-floating swap will require a
lower fixed rate applied to its outflow payments if the credit risk
or sovereign risk of the counterparty is high
Slide.39

Globalization of Swap Markets

• Foreign financial institutions and manufacturing corporations from
various counties that are exposed to interest rate risk engage in
interest rate swaps
• Swaps are executed in various countries and denominated in many
different currencies
– Dollar-denominated swaps account for about half the value of all
swaps outstanding
• Banks and securities firms that serve as intermediaries have a
globalized network of subsidiaries
• A barrier to the global swap market is the lack of information about
participants based in other countries
Slide.40

Application
• Company A has a 3 year $10 million loan outstanding with a fixed interest rate of
7.875% payable semi-annually. However Company A would prefer to be exposed to
floating interest rates since it believes that rates will trend down over the next few years.
• Company B has a $10 million floating rate bond outstanding with a maturity of 3 years.
Interest is set at Libor plus 1.25%, with rates reset every 6 months. Company B
believes that interest rates may increase over the next several years and would like to
lock into a fixed rate payment.
• The two companies enter into an interest rate swap. The notional basis for the swap is
$10 million. Company A agrees to pay to Company B Libor plus 1.375%, payable
semi-annually. Company B agrees to pay to Company A 8%, payable semi-annually.
• For the next 6 semesters, the Libor rate is respectively 6.5%; 7% ; 6,75% ; 7.25% ;
7.125% ; 6.375%
• Determine :
– The Swap Transaction (Semi-annual payments A Receives from B, payments B
Receives from A, Net Payment from B to A)
– The Company A's Position (A Owes to original Lender, Net Receipt from Swap, Net
Payment)
– The Company B's Position (B Owes to original Lender, Net Receipt from Swap, Net
Payment)
– Interpret the results.
Slide.41

Solution

Original, External Borrowing Swap Transaction

Company A Fixed 7,875% B will Pay A 8,000%
Company B Floating 1,250% Over Libor A will Pay B 1,375% Over Libor
Notional Amount $10 000 000
3 Year
Semi-annual
Year 1 Year 2 Year 3 Total
1 2 3 4 5 6
Libor 6,500% 7,000% 6,750% 7,250% 7,125% 6,375%

Swap Transaction
A Receives from B $400 000 $400 000 $400 000 $400 000 $400 000 $400 000 $2 400 000
B Receives from A $393 750 $418 750 $406 250 $431 250 $425 000 $387 500 $2 462 500
Net Payment from B to A $6 250 -$18 750 -$6 250 -$31 250 -$25 000 $12 500 -$62 500

Company A's Position

A Owes to original Lender $393 750 $393 750 $393 750 $393 750 $393 750 $393 750 $2 362 500
Net Receipt from Swap $6 250 -$18 750 -$6 250 -$31 250 -$25 000 $12 500 -$62 500
Net Payment $387 500 $412 500 $400 000 $425 000 $418 750 $381 250 $2 425 000

Company B's Position

B Owes to original Lender 387500 412500 400000 425000 418750 381250 $2 425 000
Net Receipt from Swap -$6 250 $18 750 $6 250 $31 250 $25 000 -$12 500 $62 500
Net Payment $393 750 $393 750 $393 750 $393 750 $393 750 $393 750 $2 362 500