Swaps and Interest Rate Derivatives

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Swaps and Interest Rate Derivatives

• International Corporate Finance
• P.V. Viswanath
• For use with Alan Shapiro Multinational
  Financial Management

2
Learning Objectives

• To describe how interest rate and currency swaps
  works and their function.
• To calculate the appropriate payments and
  receipts associated with a given swap.
• To describe the use of forward forwards, forward
  rate agreements and Eurodollar futures to hedge
  interest rate risk.
• To explain the nature and pricing of structured
  notes.

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Interest Rate Swaps

• Agreement between two parties to exchange dollar
  interest payments for a specific maturity on an
  agreed upon notional principal amount. No
  principal changes hands.
• In a coupon swap, one party pays a fixed rate
  calculated at the time of the trade and the other
  side pays a floating rate that resets
  periodically against a designated index.
• In a basis swap, two parties exchange floating
  interest payments based on difference reference
  rates.
• The most important reference rate is LIBOR
  (London Interbank Offered Rate) the average
  interest rate offered by a group of international
  banks in London for US dollar deposits of a
  stated maturity.

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Coupon Swaps

• Counterparties A and B both require 100 m. for a
  5-yr period. A wants to borrow at a fixed rate,
  but B wants a floating rate. A can borrow
  floating at a reasonable rate, but not fixed B
  can borrow fixed or floating at a good rate.
• There is an opportunity for profitable exchange
  because the differences in the fixed rates across
  counterparties is different from the differences
  in floating rates.
• If A borrows floating and B borrows fixed and
  they swap, both are better off, as long as A pays
  B a consideration of between 50 and 100 bps in
  the next example, A pays B 75 bps, and 10 bps to
  an intermediary.

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Coupon Swaps
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Numerical Example of Coupon Swap

• IBM issues a 2-year floating-rate bond,
  principal 100m. at LIBOR6 0.5 semiannually,
  first payment due end Dec. 2001
• It enters into a swap with Citibank
• IBM pays Citibank an annual rate of 8 in
  exchange for LIBOR6.
• All payments are on a semiannual basis.
• Effectively, IBN has converted its floating-rate
  debt into a fixed-rate bond yielding 7.5
• In this case, Citibank has taken over the risk of
  the floating rate, which it will either offset
  against other swaps in its book, or hold in
  return for the spread between a fixed 8 rate and
  a floating LIBOR6 - 50 bps. If this spread is
  large, given IBMs credit risk, Citibank has a
  NPV gt 0 transaction.

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Numerical Example of Coupon Swap
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Currency Swaps

• A currency swap is an exchange of debt-service
  obligations denominated in one currency for the
  service on an agreed upon principal amount of
  debt denominated in another currency.
• This is equivalent to a package of forward
  contracts.
• The all-in cost is the effective interest rate on
  the money raised. This is calculated as the
  discount rate that equates the present value of
  the future interest and principal payments to the
  net proceeds received by the issuer.
• The right-of-offset gives each party the right to
  offset any nonpayment by the other party with a
  comparable nonpayment.
• In an interest rate swap, there is no need for a
  swap of principals, whereas this usually does
  occur in a currency swap.

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Currency Swaps
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Currency Swaps An example

• Dow Chemical and Michelin both want to borrow
  200m. in fixed rate financing for 10 years.
• Dow can borrow in dollars at 7.5 or in euros at
  8.25
• Michelin can borrow in dollars at 7.7 and in
  euros at 8.1.
• Both companies have similar credit risks. This
  means that if Dow wants to borrow in euros and
  Michelin in dollars, they could simply swap
  payments, so that Dow gets a euro borrowing rate
  of 8.1, while Michelin gets a dollar borrowing
  rate of 7.5.
• Assuming a current spot rate of 1.1/, we can
  compute the payments between the two parties.

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Currency Swaps An example
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Interest Rate/Currency Swaps

• We can combine interest rate swaps and currency
  swaps.
• Suppose Dow wishes to borrow euros, as before,
  but at a floating rate.
• Dow can borrow euros at LIBOR 0.35, whereas
  Michelin can borrow at LIBOR 0.125
• In this case, Dow will borrow fixed dollars and
  Michelin will borrow floating euros.
• Dow will make floating euro payments to Michelin,
  while Michelin will make fixed dollar payments to
  Dow to enable each party to meet their interest
  rate commitments.
• If they simply swap the payments, Dow will save
  0.175 in interest costs, while Michelin, as
  before, will save 0.20

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Interest Rate/Currency Swaps
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Interest Rate/Currency Swap

• Kodak wishes to raise 75m. in 5 yr. fixed rate
  funds.
• Kodak issues an A200m. zero-coupon bond issue at
  a net price of 53, which realizes A106m.
• Merrill enters into a swap agreement with bank A
  to swap A70m. in 5 years at a forward rate of
  0.5286/A1.
• Merrill enters into a zero-coupon/currency swap
  with bank B
• Merrill makes the bank a zero-coupon loan in A
  at a rate of 13.39. Merrill pays the bank
  A68m. today and gets A130 in 5 years.
• The bank makes Merrill a floating rate
  -denominated loan. Merrill gets 48m. and pays
  the bank a floating rate of LIBOR - 0.40
  semi-annually and repays the 48m. in 5 years.
• The initial payments are arranged so that they
  are equal in value.
• Merrill partially hedges the LIBOR payments to
  bank B by entering into a fixed/floating swap
  with a notional value of 48m.

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Interest Rate/Currency Swap
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Interest Rate/Currency Swap
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Interest Rate/Currency Swap
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Economic Advantages of Swaps

• Comparative Advantage (but this assumes market
  inefficiency).
• A firm might choose to issue floating and swap
  into fixed if has private information that its
  credit quality spread will be lower in the
  future.
• Suppose a firm needs ten-year financing.
  However, it believes that the market has
  overestimated its default risk currently, but
  that with new information, the market will
  realize this in six months.
• One way to avoid committing itself to paying high
  interest rates for ten years, would be to issue
  short term debt however, this would expose the
  firm to interest rate risk.
• It could issue short term debt right away, say at
  LIBOR 100 bp and simultaneously do a
  fixed-for-floating swap. Then, in six months
  time, it could issue a 9.5 year floating rate
  issue at a lower spread, say at LIBOR 50 bp.

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Economic Advantages of Swaps

• Alternatively, it might believe that rates will
  increase and it is more sensitive than the market
  to interest rate changes if so, it might issue
  floating debt and swap floating for fixed. The
  market will charge a premium for such a swap if
  rates are expected to increase however, since
  the firm is more sensitive to rate changes than
  the market, this is a good deal.
• Similarly, it would choose to swap a future
  payment in one currency for another if it
  believes that the second currency is going to
  appreciate in the future to a greater degree than
  believed by the market.

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Interest Rate Forwards

• A forward forward is simply a forward contract
  that fixes an interest rate today on a future
  loan.
• A forward rate agreement separates the actual
  loan from the interest rate risk. It is
  equivalent to a forward forward, where the
  contract is cancelled at the date that the loan
  is to be initiated, and payments are made to make
  the losing party whole. Also, the risk of
  changes in borrower default risk are borne by the
  borrower.
• Suppose Unilever has an agreement to borrow 50m.
  in 2 months for a duration of 6 months at a
  forward rate of 6.5 LIBOR. Two months later,
  actual spot LIBOR is 7.2.
• If Unilever did not have the agreement, it would
  have to pay 0.072(50m)(182/360) 1.82m. in 6
  months time. Because of the agreement, it need
  pay 0.065(50m)(182/360) 1.64m only.
• Hence there is a saving of (1.82-1.64)/(10.072(18
  2/360)) 0.17073m.

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Eurodollar futures

• Eurodollar futures are cash-settled futures
  contracts on a three-month, 1m. eurodollar
  deposit that pays LIBOR.
• They are traded on the CME, the LIFFE and the
  SIMEX.
• They are effectively standardized FRAs.
• Unlike FRAs, futures contracts are marked to
  market at the end of every day. In contrast, an
  FRA is marked-to-market only when the contract
  matures.
• Furthermore, the notional value of an FRA is the
  amount to be borrowed, while the notional value
  in a eurodollar futures contract is the amount to
  be paid at maturity.

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Eurodollar futures pricing

• The price of a Eurodollar futures contract is
  quoted as an index number equal to 100 minus the
  annualized forward interest rate. If the current
  futures price is 91.68, the value of this
  contract at inception 1m.1-0.0832(90/360)
  979,200, since 100-91.68 0.0832.
• If the price rises to 100-7.54 92.46, the
  contract value rises to 1m.1-0.0754(90/360)
  981,150. Consequently, the buyer gets the
  difference of 1950 from the seller, right away.
• Hence a basis point increase in the futures price
  is worth 1950/(9246-9168) 25.
• A firm intending to borrow money in the
  Eurodollar market in the future would sell a
  Eurodollar futures contract one intending to
  lend money would buy.

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Structured Notes

• Interest bearing securities whose interest
  payments are determined by reference to a formula
  set in advance and adjusted on specified reset
  dates.
• These factors can include LIBOR, exchange rates,
  commodity prices or any combination thereof.
• FRN interest payment tied to LIBOR.
• Inverse floater interest rate moves inversely
  with market rates, e.g. nr (n-1)LIBOR, where r
  is the market rate on a fixed rate bond, with
  periodic rate resetting. The volatility is n
  times the volatility of a fixed rate bond.
• Step-down notes debt instruments with a high
  coupon in earlier payment periods and a lower
  coupon in later periods for tax reasons, an
  investor might want to front-load his interest
  income.