part3d swap
TRANSCRIPT
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IIID Interest Rate and Currency Swaps
Read ch 14 (pp. 466-485)
1. Defining interest rate risk
2. Management of interest rate risk
3. Example: Carlton interest rate swap
4. Example: Carlton currency swap
5. Counterparty risk
6. Example: A three-way swaps
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1. Defining Interest Rate Risk
All firms domestic or multinational, small or large,
leveraged, or unleveraged are sensitive to interestrate movements in one way or another.
Sources of interest rate risk for a nonfinancial firm:
debt service; the multicurrency dimension of interest
rate risk for the MNE is of serious concern.
holdings of interest-sensitive securities.
A reference rate is the rate of interest used in a
standardized quotation, and loan agreements.LIBOR (London Interbank Offered Rate) is the most
widely used reference rate.
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2. Management of Interest Rate Risk
Before treasurers and financial managers can
manage interest rate risk, they must resolve a basicmanagement dilemma: the balance between riskand return.
Treasury has traditionally been considered a service
center (cost center) and is therefore not expected totake positions that incur risk in the expectation of
profit (treasury management practices are rarelyevaluated as profit centers).
Treasury management practices are thereforepredominantly conservative, but opportunities toreduce costs or actually earn profits are not to beignored.
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2. Management of IR risk
As in foreign exchange management exposure, the
firm needs expectations a directional and/orvolatility view on interest rate movements for the
effective management of interest rate risk.
Fortunately, interest rate movements have historicallyshown more stability and less volatility than foreign
exchange rate movements.
Once management has formed expectations about
future interest rate levels and movements, it mustchoose the appropriate implementation timing,
location of market, instruments, etc.
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Credit risk, orroll-over risk, is the possibility that the
lender reclassifies a borrowers credit worthiness whenrenewing a credit (with changes in fees, interest rates,
credit line commitments or even denial of credit).
Repricing riskis the risk of changes in interest rates at
the time a financial contracts rate is reset. Consider the three choices of $1 million loan:
Three year at a fixed interest rate
Three year at LIBOR+2%, to be reset annually One year at a fixed interest rate, and renew the credit
annually.
2. Management of IR risk: credit and repricingrisk
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Example: Carlton Corporation has taken out a $10
million three-year, floating-rate loan, with annualinterest payments, and 1.5% flat initiation fee
payable upfront.
Assuming 5% p.a. for LIBOR, cash flows are
$9.85m, -$0.65m, -$0.65m, -$10.65m, resulting in aninternal rate of return of 7.02%. We call this the all-in-cost (AIC) of the loan.
Some alternatives to manage interest rate risk are:
Refinancing
Forward rate agreements
Interest rate futures
Interest rate swaps
2. Management of IR risk: floating rate loan
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Aforward rate agreement(FRA) is an interbank-tradedcontract to buy or sell interest rate payments on anotional principal. Maturities of the contracts aretypically 1, 3, 6, 9 and 12 months.
Example: Carlton buys an FRA that locks in the firstinterest payment (due at the end of year 1) at 5% p.a.
If LIBOR rises above 5% at the end of year 1, Carltonreceives a payment for the differential interest rates,
If LIBOR falls below 5% at the end of year 1, Carltonmakes a payment for the differential interest rates.
Due to limited maturities and currencies available, FRAsare not widely used outside the largest industrialeconomies and currencies.
A series of FRAs is an interest rate swap.
2. Management of IR risk: forward rateagreement
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Unlike foreign currency futures, nonfinancial
companies relatively widely use interest rate futures. They are popular due to the relatively high liquidity,
simplicity in use, and the standardized interest-rate
exposures most firms possess.
The two most widely used futures contracts are the
Eurodollar and the US Treasury Bond futures traded
on the Chicago Mercantile Exchange (CME).
2. Management of IR risk: interest ratefutures
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2. Management of IR risk: interest ratefutures Each contract is for a three-month period with a
notional principal of $1 million. Each percentagepoint is worth $2,500 ($1m*0.01*90/360).
Yield = 100.00 settlement price
Suppose Carlton Crop sells a one-year futures
contract at a price of 94.76, or at a yield of 5.24%(100.00 94.76).
If interest rates (yields) rise by the maturity date, thefutures price will fall, and Carlton can close the
position at a profit.The profit will offset the losses on the LIBOR
borrowing due to rising interest rates.
In effect, Carlton can lock in interest rate of 5.24%.
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Interest rate futures strategies for common exposures:
Paying interest on a future date: sell a futures contractand create a short position
If rates go up, the futures price falls and the short earnsa profit (offsets loss on interest expense)
If rates go down, the futures price rises and the shortearns a loss
Earning interest on a future date: buy a futures contractand create a long position
If rates go up, the futures price falls and the short earnsa loss
If rates go down, the futures price rises and the longearns a profit
2. Management of IR risk: interest ratefutures
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Swaps are contractual agreements to exchange or
swap a series of cash flows. These cash flows are most commonly the interest
payments associated with debt service.
interest rate swap: Exchange fixed interest rate payments
for the floating interest rate payments.
currency swap: Exchange currencies of debt service
obligation (e.g. from SF loan to $ loan).
interest rate and currency swap: A single swap maycombine elements of both.
2. Management of IR risk: interest rateswaps
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The swap itself is not a source of capital, but rather
an alteration of the cash flows associated withpayment.
What is often termed theplain vanilla swap is an
agreement between two parties to exchange fixed-
rate for floating-rate financial obligations.
This type of swap forms the largest single financial
derivative market in the world.
2. Management of IR risk: interest rateswaps
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Suppose ABC Inc holding a floating-rate debt
conclude that interest rates are about to rise. The finance manager of ABC may wish topay fixed
and to receive floating interest payments.
If XYZ concludes that interest rates will fall. Then
XYZ may wish topay floating and to receive fixed
interest payments on their fixed-rate debt.
There is an incentive for the two parties to enter into
an interest rate swap.
Interest rate swap exploits a mispricing in two
markets.
2. IR risk: Why interest rate swaps?
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Exhibit 14.8 Comparative advantage and structure ofa swap
The firms borrow in their relatively advantaged market and swap.
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Unilever borrows at 7% p.a., and then enters into
interest rate swap with Citibank.
Unilever agrees to pay Citibank a floating rate of
interest and to receive one-year LIBOR.
Xerox borrows at LIBOR+3/4%, and then swaps thepayments with Citibank.
Xerox agrees to pay Citibank 7.875% p.a. interest
and to receive LIBOR+3/4%.
Net borrowing cost are:
LIBOR for Unilever (saving of % p.a.)
7.875% p.a. for Xerox (saving of 1/8% p.a.)
2. IR risk: Implementation of interest rateswaps
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Consider Carltons $10 million 3-year loan atLIBOR+1.5%. Suppose management believes that
the LIBOR may be rising.
Alternatives:
refinancing: too expensive
interest rate forward: management is not familiar with it.
interest rate swap
Carlton enters into a float-to-fixed swap.
Carlton receives LIBOR and pays 5.75% p.a.
All-in-cost of the loan is 7.25% (5.75%+1.5% spread).Note that the swap agreement applies only to the interest
payments on the loan and not the principal payments.
3. Example: Carlton swapping to fixedrates.
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The usual motivation for a currency swap is to
replace cash flows scheduled in an undesiredcurrency with flows in a desired currency.
The desired currency is probably the currency in
which the firms future operating revenues
(inflows) will be generated.
Firms often raise capital in currencies in which they
do not possess significant revenues or other natural
cash flows (a significant reason for this being cost).
Interest rate risk: currency swap
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Carlton borrows $10m for 3 years at LIBOR+1.5%.
Carlton enters into a float-to-fixed swap at 5.75% p.a.
Carlton prefers to make its payments in SF, given a naturalinflow of SF from sales contracts.
Carlton enters into a three-year currency swap topay 2.01%
SF interest and to receive 5.56% fixed dollars. Current spotrate is SF1.50/$. Carltons cash flows are
4. Example: Carltons currency swap
year 0 year 1 year 2 year 3
receive $10m $0.556m $0.556m $10.556mpay SF15m SF0.3015m SF0.3015m SF15.301m
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The Carltons three-year currency swap is different
from the plain vanilla interest rate swap:The spot exchange rate on the date of the agreement
establishes the notional principal amount in SF.
The notional principal itself is part of the swap
agreement.
On the date of the agreement, the NPV of cash
flows to the two parties of the swap is zero.
As spot rate changes over the life of the swap, theNPV of cash flows under the swap changes.
4. Example: Carltons currency swap
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A detailed look at a currency swap
SCC, a Swiss Co, will issue a SF debt to swap SF for
dollar if it can get $-funds below 11.875% p.a..Principal = SF 100 m. 6 year maturity
Coupon = 5% p.a. Floatation costs = 2.25% flat fee.
Air Canada(AC)will issue a $-bond and swap dollarfor SF if it can get SF-funds at a rate of 5.5% p.a.
PV of the SF debt at 5.5% p.a. to ACis:
i=1,6
SF100*.05/(1+ .055)i + SF100/1+0.55)
=SF95.502m
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ACwill pay $-equivalent of SF97.502m to SCC:
SF 97.502 * ($.50/SF) = $48.751m Assume a floatation cost of 2.125% flat, AC must
issue a $49.809m bond so that
$49.809*(1 - .02125) = $48.751m net proceeds. Dollar bond issue by Air Canada:
Principal = $49.809 m, 6 year maturity
Coupon = 11.25% p.a., Floatation costs = 2.125%
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PV of debt plus swap to SCC:
[SF100*(1 - .0225) - SF97.502]*spot rate
+ $49.809*(1 - .02125)
- i=1,6 $49.809*0.1125/(1+ )j - $49.809/ (1 + ) 6
The IRR on this cash flow is = 11.70% p.a., so the
SCC, the Swiss firm, obtains funds at less than11.875% p.a.
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Value of a swap
Air Canada issues $ debt and swaps into SF debt.
The swap is like:(1) purchasing $ bond (since it will receive $
interest and principal), and
(2) selling SF bond (since it must pay SF interest
and principal)
So, value of swap to Air Canada is:
Value of $ bond - Value of SF bond.
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Example: Value of swap to Air CanadaAC issues a 5-year $20 m bond with 8% p.a. coupon and
swaps into a 5-year SF 40 m debt with 10% p.a. coupon.
Today Year 1
spot rate (SF/S) 2.00 1.80
$ interest rate 8% p.a. 7% p.a.
SF interest rate 10% p.a. 8% p.a.Cash flows annual interest:
At maturity:
+$1.6m, -SF4m
+$20m, -SF40m
value of $-bond $0 $20.677m
value of SF-bond $0 $23.694m
Value of swap $0 -$3.017m
Why value changes? stronger sf and relatively large drop in isf
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As with all original loan agreements, it may happen
that at some future date the partners to a swap maywish to terminate the agreement before it matures.
Unwindinga currency swap requires the
discounting of the remaining cash flows under theswap agreement at current interest rates, then
converting the target currency (Swiss francs) back
to the home currency (dollars) of the firm.
Carlton: unwinding swaps
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5. Counterparty Risk
Counterparty riskis the potential risk that the second
party to a financial contract will be unable to fulfill itsobligations.
Counterparty risk has long been one of the major
factors that favor the use of exchange-traded rather
than over-the-counter derivatives.
The real exposure of a swap is not the total notional
principal, but the mark-to-market values of
differentials in interest or currency interest payments. This differential is similar to the change in swap
value, and typically about 2-3% of the notional
principal.
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Example: A three-way back-to-back cross-currency swap Individual firms often find special demands for their debt in
select markets, allowing them to raise capital at several
points lower there than in other markets.
Thus, a growing number of firms are confronted with debt
service in currencies that are not normal for their operations.
The result has been a use of debt issuances coupled with
swap agreements from inception.
The following exhibit depicts a three-way borrowing plus
swap structure between a Canadian province, a Finnishexport agency, and a multilateral development bank.
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Finish Export Credit(Finland)
Province of Ontario(Canada)
Inter-American
Development Bank
Borrows $390 million
at US Treasury + 48 basis points
$260
million
$130
million
Borrows C$300 million
at Canadian Treasury + 47 basis points
Borrows C$150 million
at Canadian Treasury + 44 basis points
C$300
million
C$150
million
Exhibit 14.12 A Three-way Back-to-BackCross-Currency Swap
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Case: McDonalds Corporations British PoundExposure
How does the cross-currency swap effectively
hedge the three primary exposures of McDonaldshas relative to its British subsidiary?
How does the cross-currency swap hedge the long-
term equity exposure in the foreign subsidiary?
Should Anka and McDonalds worry about
OCI?
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Chapter 14 Appendix: Advanced Topics
An interest rate cap is an option to fix a ceiling or
maximum short-term interest-rate payment.
The contract is written such that the buyer of the
cap will receive a cash payment equal to the
difference between the actual market interest rateand the cap strike rate on the notional principal, if
the market rate rises above the strike rate.
Like any option, the buyer of the cap pays a
premium to the seller of the cap up front for this
right.
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An interest rate floorgives the buyer the right
to receive the compensating payment (cashsettlement) when the reference interest rate falls
below the strike rate of the floor.
Chapter 14 Appendix: Advanced Topics
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No theoretical limit exists to the specification of
caps and floors. Most currency cap markets are liquid for up to ten
years in the over-the-counter market, though the
majority of trading falls between one and five
years.
An added distinction that is important to
understanding cap maturity has to do with the
number of interest rate resets involved. A common interest rate cap would be a two-year
cap on three-month LIBOR.
Chapter 14 Appendix: Advanced Topics
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The value of a capped interest payment is
composed of three different elements (3-year, 3-
month LIBOR reference rate cap):
The actual three-month payment
The amount of the cap payment to the cap buyerif the reference rate rises above the cap rate
The annualized cost of the cap
Chapter 14 Appendix: Advanced Topics
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Interest rate floors are basically call options on an
interest rate, and equivalently, interest rate floors
are put options on an interest rate.
Afloorguarantees the buyer of the floor option a
minimum interest rate to be received (rate of return
on notional principal invested) for a specifiedreinvestment period or series of periods.
The pricing and valuation of a floor is the same as
that of an interest rate cap.
Chapter 14 Appendix: Advanced Topics
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Interest Rate
Payment (%)
Actual 3-month LIBOR on reset date (%)
5.00
5.50
6.00
6.50
7.00
5.50 6.00 6.50 7.50 8.007.00
7.50
Uncovered interest
rate payment
Capped interest
rate payment
The effective cap
Exhibit 14A.2 Profile of an Interest Rate Cap
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German firms effective
investment rate (%)
6-month DM LIBOR on reset date (%)
4.00
4.50
5.00
5.50
6.00
4.50 5.00 5.50 6.50 7.006.00
6.50
Uncovered interest
earnings
Interest earnings
with floor
The effective floor
Exhibit 14A.3 Profile of an Interest Rate Floor
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An interest rate collar is the simultaneous purchase
(sale) of a cap and a sale (purchase) of a floor.
The firm constructing the collar earns a premiumfrom the sale of one side to cover in part of in fullthe premium expense of purchasing the other sideof the collar.
If the two premiums are equal, the position is oftenreferred to as azero-premium collar.
Chapter 14 Appendix: Advanced Topics
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Firms interest
rate payment (%)
Actual market interest rate (%)
0.00
2.00
4.00
6.00
8.00
0.5 1.5 3.5 5.5 6.54.5
Uncovered interest
rate payment
Interest rate cap
2.5
1.00
3.00
5.00
7.00
9.00
Interest rate floor
Floor strike
rate
Cap strike
rate
Exhibit 14A.4 Profile of an Interest Rate Collar
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The purchase of a swap option, aswaption, givesthe firm the right but not the obligation to enter into
a swap on a pre-determined notional principal atsome defined future date at a specified strike rate.
A firms treasurer would typically purchase a
payers swaption, giving the treasurer the right toenter a swap in which they pay the fixed rate andreceive the floating rate.
Chapter 14 Appendix: Advanced Topics