INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
10Chapter TenCurrency & 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.
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
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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
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.
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%)
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,
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.
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 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 + ? percent.
? Firm B would prefer to borrow at a fixed rate.
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reserved,
10-8
An Example of an Interest Rate Swap
The borrowing opportunities of the two firms are
shown in the following table:
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
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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
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
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reserved,
10-10
10 3/8%
LIBOR – 1/8%
An Example of an Interest Rate Swap
Bank
A
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 – ? % which is ? %
better than they can borrow
floating without a swap,
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
10%
? % of $10,000,000 =
$50,000,That’s quite a
cost savings per year for 5
years.
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reserved,
10-11
LIBOR – ?%
10 ?%
An Example of an Interest Rate Swap
Swap
Bank
Company
B
The swap bank makes this
offer to company B,You
pay us 10 ? % per year on
$10 million for 5 years
and we will pay you
LIBOR – ? % per year on
$10 million for 5 years.
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
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reserved,
10-12
LIBOR – ?%
10 ?%
An Example of an Interest Rate Swap
Swap
Bank
Company
B
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
They can borrow externally at LIBOR + ? %
and have a net borrowing position of
10? + (LIBOR + ? ) - (LIBOR - ? ) = 11.25%
which is ? % better than they can borrow
floating without a swap,
LIBOR
+ ?%
Here’s what’s in it for B,? % of $10,000,000 = $50,000 that’s quite a cost
savings per year for 5
years.
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reserved,
10-13
LIBOR
+ ?%
10 3/8 %
LIBOR – 1/8% LIBOR – ?%
10 ?%
B saves ? %
An Example of an Interest Rate Swap
Bank
A
Swap
Bank
Company
B
A saves ? %
The swap bank
makes money too.
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
10%
? % of $10 million
= $25,000 per year
for 5 years.
LIBOR – 1/8 – [LIBOR – ? ]= 1/8
10 ? - 10 3/8 = 1/8
?
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reserved,
10-14
LIBOR
+ ?%
10 3/8 %
LIBOR – 1/8% LIBOR – ?%
10 ?%
B saves ? %
An Example of an Interest Rate Swap
Bank
A
Swap
Bank
Company
B
A saves ? %
The swap bank
makes ? %
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
10% Note that the total savings
? + ? + ? = 1.25 % = QSD
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reserved,
10-15
The QSD
? The Quality Spread Differential represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
? There is no reason to presume that the gains will
be shared equally.
? In the above example,company B is less credit-
worthy than bank A,so they probably would have
gotten less of the QSD,in order to compensate the
swap bank for the default risk.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
10-16
An Example of a Currency Swap
? Suppose a U.S,MNC wants to finance a
￡10,000,000 expansion of a British plant.
? They could borrow dollars in the U.S,where they
are well known and exchange for dollars for
pounds.
? This will give them exchange rate risk,financing a
sterling project with dollars.
? They could borrow pounds in the international
bond market,but pay a lot since they are not as
well known abroad.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
10-17
An Example of a Currency Swap
? If they can find a British MNC with a mirror-
image financing need they may both benefit from
a swap.
? If the exchange rate is S0($/￡) = $1.60/￡,the U.S,
firm needs to find a British firm wanting to
finance dollar borrowing in the amount of
$16,000,000.
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reserved,
10-18
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 U.K.–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.
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
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reserved,
10-19
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
B
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reserved,
10-20
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
BA’s net position is to borrow at ￡11%
A saves ￡.6%
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reserved,
10-21
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
B
B’s net position is to borrow at $9.4%
B saves $.6%
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reserved,
10-22
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
B
The swap bank makes
money too:
At S0($/￡) = $1.60/￡,that
is a gain of $124,000 per
year for 5 years,The swap bank
faces exchange rate
risk,but maybe
they can lay it off
in another swap.
1.4% of $16 million
financed with 1% of ￡10
million per year for 5
years.
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reserved,
10-23
A is the more credit-worthy of the two firms.
Comparative Advantage
as the Basis for Swaps
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.
A pays 2% less to borrow in dollars than B
A pays,4% less to borrow in pounds than B:
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reserved,
10-24
B has a comparative advantage in borrowing in ￡.
Comparative Advantage
as the Basis for Swaps
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
B pays 2% more to borrow in dollars than A
B pays only,4% more to borrow in pounds than A:
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reserved,
10-25
A has a comparative advantage in borrowing in
dollars.
B has a comparative advantage in borrowing in
pounds.
If they borrow according to their comparative
advantage and then swap,there will be gains for
both parties.
Comparative Advantage
as the Basis for Swaps
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reserved,
10-26
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‖ swaps and
provide quotes for these,Since the swap banks are dealers
for these swaps,there is a bid-ask spread.
? For example,6.60 — 6.85 means the swap bank will pay
fixed-rate DM payments at 6.60% against receiving dollar
LIBOR or it will receive fixed-rate DM payments at 6.85%
against receiving dollar LIBOR.
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reserved,
10-27
Variations of Basic Currency and
Interest Rate Swaps
? Currency Swaps
? fixed for fixed
? fixed for floating
? floating for floating
? amortizing
? Interest Rate Swaps
? zero-for floating
? floating for floating
? For a swap to be possible,a QSD must exist,
Beyond that,creativity is the only limit.
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reserved,
10-28
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,
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reserved,
10-29
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.
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reserved,
10-30
Pricing a Swap
? A swap is a derivative security so it can be priced
in terms of the underlying assets:
? How to:
? Plain vanilla fixed for floating swap gets valued just
like a bond.
? Currency swap gets valued just like a nest of currency
futures.
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reserved,
10-31
Swap Market Efficiency
? Swaps offer market completeness and that has
accounted for their existence and growth.
? Swaps assist in tailoring financing to the type
desired by a particular borrower,Since not all
types of debt instruments are available to all types
of borrowers,both counterparties can benefit (as
well as the swap dealer) through financing that is
more suitable for their asset maturity structures.
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reserved,
10-32
Concluding Remarks
? The growth of the swap market has been
astounding.
? Swaps are off-the-books transactions.
? Swaps have become an important source of
revenue and risk for banks
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reserved,
10-33
End Chapter Ten
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
10Chapter TenCurrency & 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.
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
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
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.
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%)
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,
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.
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 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 + ? percent.
? Firm B would prefer to borrow at a fixed rate.
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:
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
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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
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
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reserved,
10-10
10 3/8%
LIBOR – 1/8%
An Example of an Interest Rate Swap
Bank
A
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 – ? % which is ? %
better than they can borrow
floating without a swap,
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
10%
? % of $10,000,000 =
$50,000,That’s quite a
cost savings per year for 5
years.
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reserved,
10-11
LIBOR – ?%
10 ?%
An Example of an Interest Rate Swap
Swap
Bank
Company
B
The swap bank makes this
offer to company B,You
pay us 10 ? % per year on
$10 million for 5 years
and we will pay you
LIBOR – ? % per year on
$10 million for 5 years.
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
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reserved,
10-12
LIBOR – ?%
10 ?%
An Example of an Interest Rate Swap
Swap
Bank
Company
B
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
They can borrow externally at LIBOR + ? %
and have a net borrowing position of
10? + (LIBOR + ? ) - (LIBOR - ? ) = 11.25%
which is ? % better than they can borrow
floating without a swap,
LIBOR
+ ?%
Here’s what’s in it for B,? % of $10,000,000 = $50,000 that’s quite a cost
savings per year for 5
years.
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reserved,
10-13
LIBOR
+ ?%
10 3/8 %
LIBOR – 1/8% LIBOR – ?%
10 ?%
B saves ? %
An Example of an Interest Rate Swap
Bank
A
Swap
Bank
Company
B
A saves ? %
The swap bank
makes money too.
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
10%
? % of $10 million
= $25,000 per year
for 5 years.
LIBOR – 1/8 – [LIBOR – ? ]= 1/8
10 ? - 10 3/8 = 1/8
?
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reserved,
10-14
LIBOR
+ ?%
10 3/8 %
LIBOR – 1/8% LIBOR – ?%
10 ?%
B saves ? %
An Example of an Interest Rate Swap
Bank
A
Swap
Bank
Company
B
A saves ? %
The swap bank
makes ? %
C OMPA NY B B A NK A DI F F E R E NTI A L
F ixe d rate 1 1,7 5 % 10% 1,7 5 %
F loa ti n g rate L I B OR +,5 % L I B OR,5 %
QS D = 1,2 5 %
10% Note that the total savings
? + ? + ? = 1.25 % = QSD
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reserved,
10-15
The QSD
? The Quality Spread Differential represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
? There is no reason to presume that the gains will
be shared equally.
? In the above example,company B is less credit-
worthy than bank A,so they probably would have
gotten less of the QSD,in order to compensate the
swap bank for the default risk.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
10-16
An Example of a Currency Swap
? Suppose a U.S,MNC wants to finance a
￡10,000,000 expansion of a British plant.
? They could borrow dollars in the U.S,where they
are well known and exchange for dollars for
pounds.
? This will give them exchange rate risk,financing a
sterling project with dollars.
? They could borrow pounds in the international
bond market,but pay a lot since they are not as
well known abroad.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
10-17
An Example of a Currency Swap
? If they can find a British MNC with a mirror-
image financing need they may both benefit from
a swap.
? If the exchange rate is S0($/￡) = $1.60/￡,the U.S,
firm needs to find a British firm wanting to
finance dollar borrowing in the amount of
$16,000,000.
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10-18
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 U.K.–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.
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
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An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
B
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10-20
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
BA’s net position is to borrow at ￡11%
A saves ￡.6%
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10-21
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
B
B’s net position is to borrow at $9.4%
B saves $.6%
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10-22
An Example of a Currency Swap
Company
A
Swap
Bank
$8% ￡12%
$8%
￡11% ￡12%
$9.4%
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
Company
B
The swap bank makes
money too:
At S0($/￡) = $1.60/￡,that
is a gain of $124,000 per
year for 5 years,The swap bank
faces exchange rate
risk,but maybe
they can lay it off
in another swap.
1.4% of $16 million
financed with 1% of ￡10
million per year for 5
years.
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10-23
A is the more credit-worthy of the two firms.
Comparative Advantage
as the Basis for Swaps
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.
A pays 2% less to borrow in dollars than B
A pays,4% less to borrow in pounds than B:
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B has a comparative advantage in borrowing in ￡.
Comparative Advantage
as the Basis for Swaps
$ ￡
Co m p a ny A 8,0% 1 1,6%
Co m p a ny B 1 0,0% 1 2,0%
B pays 2% more to borrow in dollars than A
B pays only,4% more to borrow in pounds than A:
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10-25
A has a comparative advantage in borrowing in
dollars.
B has a comparative advantage in borrowing in
pounds.
If they borrow according to their comparative
advantage and then swap,there will be gains for
both parties.
Comparative Advantage
as the Basis for Swaps
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10-26
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‖ swaps and
provide quotes for these,Since the swap banks are dealers
for these swaps,there is a bid-ask spread.
? For example,6.60 — 6.85 means the swap bank will pay
fixed-rate DM payments at 6.60% against receiving dollar
LIBOR or it will receive fixed-rate DM payments at 6.85%
against receiving dollar LIBOR.
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Variations of Basic Currency and
Interest Rate Swaps
? Currency Swaps
? fixed for fixed
? fixed for floating
? floating for floating
? amortizing
? Interest Rate Swaps
? zero-for floating
? floating for floating
? For a swap to be possible,a QSD must exist,
Beyond that,creativity is the only limit.
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10-28
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,
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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.
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10-30
Pricing a Swap
? A swap is a derivative security so it can be priced
in terms of the underlying assets:
? How to:
? Plain vanilla fixed for floating swap gets valued just
like a bond.
? Currency swap gets valued just like a nest of currency
futures.
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10-31
Swap Market Efficiency
? Swaps offer market completeness and that has
accounted for their existence and growth.
? Swaps assist in tailoring financing to the type
desired by a particular borrower,Since not all
types of debt instruments are available to all types
of borrowers,both counterparties can benefit (as
well as the swap dealer) through financing that is
more suitable for their asset maturity structures.
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10-32
Concluding Remarks
? The growth of the swap market has been
astounding.
? Swaps are off-the-books transactions.
? Swaps have become an important source of
revenue and risk for banks
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10-33
End Chapter Ten
