SWAPS

1
SWAPS

• 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
• Example
• 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

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SWAPS

• 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

3
SWAPS

• 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.

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SWAPS

• Why short-term Swaps exist?
• 1. Safety
• 2. Reduction of Transaction Costs
• 3. Tax Avoidance
• 4. Religious objections against interest
• 5. Fictitious Transactions

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SWAPS

• Why short-term Swaps exist? (cont.)
• 1. Safety
• Example
• 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 ? low bid-ask spread ('haircut')

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SWAPS

• Why short-term Swaps exist? (cont.)
• 2. Reduction of transaction costs
• If an investor intends to reverse the transaction
• Example
• 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

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SWAPS

• Why short-term Swaps exist? (cont.)
• 3. Tax Avoidance
• When capital gains are taxed at a lower rate
• Example
• Buy 10 kilos of gold from a bank at the spot
  price St LUF 5m
• and sell it back (forward) at Ft,T St (1rt,T)
  5.25m
• This is a disguised deposit of LUF 5m at 5, but
  the return is
• a capital gain

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SWAPS

• 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

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SWAPS

• 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)

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SWAPS
Back-to-back loans (cont.)
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SWAPS

• 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 others subsidiary), with a
  right of offset
• in the two loan contracts

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SWAPS

• 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

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SWAPS

• 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 IBMs foreign debt instead

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SWAPS

• The 1981 IBM/World Bank Currency Swap(cont.)
• Specifically,
• 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 IBMs old DEM and CHF loans,
• ... while IBM promised to provide the WB with the
  USD needed
• to service the WB's (new) USD loan

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SWAPS

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

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.
16
SWAPS

• The 1981 IBM/World Bank Currency Swap(cont.)
• Example
• IBMs DEM debt is DEM 10m at 5 maturing within 5
  years
• The current 5-year DEM interest rate is 10 and
• St USD/DEM 0.4
• Market value of service payments
• (1) DEM 10m 1 (.05 - .1) a(10 , 5 years)
  
• DEM 8.105m
• or 8.105 .4 USD 3.242m. So the USD loan
  should also be
• worth USD 3.242m.

17
SWAPS

• 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,
  St2.5
• PVUSD USD 100 and
• PVGBP GBP 40, or USD 100

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SWAPS

• 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 contracts
  right-of-offset
• remaining risks are largely eliminated by
  screening of
• the customers, and by margins or other pledges

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SWAPS

• 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

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SWAPS
Characteristics of the Modern Currency Swap
(cont.) The deal is structured as one single
contract, with a right of offset Example
Leg 1 (DEM) leg 2 (USD) 18m at 8 10m at
7 (lent) (borrowed)
Initial exchange of principals ltDEM 18.0mgt USD
10.0m annual interest payments DEM 1.44m ltUSD
0.7mgt payment of principal at T DEM
18.0m ltUSD10.0mgt
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SWAPS
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 banks inflows is the
same as the uncertainty about the banks
outflow side. Thus, the corrections for
(minute) risk virtually cancel out
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SWAPS
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 Example (2) PVUSD USD
10m, (3) PVDEM DEM 18m which implies that
the PV in USD is 18m/1.8 USD 10m
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SWAPS
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 Example 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
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SWAPS

• Coupon Swaps (Fixed-for-Floating)
• Characteristics of the Fixed-for-Floating Swap
• Example
• 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
• LIBOR1 vs 19 swap rate 3

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SWAPS

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

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SWAPS

• Base Swaps
• Example IN T-bill rate / OUT Eurodollar
  (LIBOR)
• Why?
• To speculate on the TED spread
• (For a swap dealer) to hedge two (unrelated)
  coupon
• swapsone where IN is LIBOR and OUT is T-bill

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SWAPS

• Cross-Currency Swaps

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SWAPS

• Cocktail Swap

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SWAPS

• Conclusions
• Swaps allow a company to
• borrow in the market where it can obtain the
  lowest spread
• exchange the risk-free component of the loans
  service
• payments for the risk free component of a
  another loan
• that is thought to be more suitable

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SWAPS

• Case. An Interest Rate Swap Will it work?

Basket Corporation
Metro Bank
Sushi Bank
Fixed Rate Payer 12 Fixed
Floating Rate Swap LIBID (-)1/8
Target Rates At least 12 basis points
Basket
Basket
Fixed Reference Rate - 7 year note - All in cost
127/8 12.875
Floating Reference Rate - Commercial - Paper
rate 1/2 fee 93/8 1/2 97/8
Sushi Bank can issue 7-yr Eurobond at 12
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SWAPS

• Case. An Interest Rate Swap Will it work?
  (cont.)
• LIBOR (overnight) 9
• Basis Swap 7 days 91/8
• 1 month 92/8
• 3 months 93/8
• 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

CP 1/4 Vs. LIBOR
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SWAPS

• Case. An Interest Rate Swap Will it work?
  (cont.)
• From Sushi Bank
• Point of View
• Sushi receives reference 11.66 ie
  112/3
• 12
• Sushi pays LIBOR - 1/2
• Reference LIBOR - 1/8
• Total Gain to Sushi Bank 1/3 - 1/8 1/12
• 3/8 - 1/3 (9-8)/24 1/24

1/3 loss
(-) 3/8 gain
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SWAPS

• 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