topic 9 transaction exposure management (3)840145.72116.30la.com.cn/wenjian/8transaction exposure...

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Topic 7 Transaction Exposure Management (3)

Swap Market Hedge

2

Meaning of Swap

Essence

Basic types

- Currency swap

- Interest rate swap

- Basis swap

- Cross currency coupon swap

3

Development Background

Parallel loan

Back to back loan

Telecommunication

Financial liberalization

4

Parallel Loan

UK parent

UK Subsidiary

in US

US parent

US Subsidiary

in UK

￡ $

UK US

5

Drawbacks of Parallel Loan

The loans were legally two separate transactions with two distinct sets of borrowers and lenders- no right of offset.

Transactions impacted on the balance sheet like conventional loans.

6

UK company

US subsidiary

US company

UK subsidiary

$

$

￡

￡

Back-to-Back Loan

UK US

7

Shortcomings of Back-to-Back Loans

Legal and accounting treatment is ambiguous.

The legal uncertainty is increased by the cross-border structure.

8

Basic Categories of Financial Swaps

Currency Swap

Interest Rate Swap

Cross Currency Coupon Swap

Basis Swap

9

Currency Swap

Fixed rate-for-fixed rate currency swap

- Only the principal amount is exchanged

10

Fixed-for-fixed rate Currency Swap- example

UK company

Project in France

€30m

Borrow?Buy?

Swap?

11


£ 20m

Swap Agreement:

• Maturity : 2 years

• Amount : £ 20m, €30m

• Swap exchange rate:£1= € 1.5

Project in France

UK Company

Bank

€30m €30m

2 years later: € profit

12


银行

€30m

€ interest

£ interest

£ 20m

€30m

2 years later: € profit

£ 20m

Project in France

UK Company

€30m

13

Three Steps of Currency Swap

Initial exchange of principal

Periodic payment of interest

Re-exchange of principal

14

Purposes of Currency Swap

Financing

Currency risk management

Capital market arbitrage

15

Capital Market Arbitrage A Canadian company needs fixed rate euro

financing .

Credit rating in Frankfurt: BBB

Credit rating in New York :AA+

Decision: Obtain $ financing first, then do a currency swap

16

Capital Market Arbitrage - example

Canadian Company

New York

Bank$$

€

Project in Germany

€

$ $

€

profit

€Note: three steps are still involved

Currency

SwapFinancing

Project Investment

17

World Bank’s Financial Sources &

Development Loans

Source 1 :

- Member’s quota

Source 2:

- Bond financing

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World Bank’s Financing and Project Loan

FrankfurtWorld Bank

Bank

Bond

€ €

$

China

$€€

$

$

Bond issuing

Currency swap

Project loan

19

What is a Currency Swap

A currency swap is a contract which commits two counterparties to exchange, over an agreed period, two streams of interest payments in different currencies and, at the end of the period, to exchange the corresponding principal amounts at an exchange rate agreed at the start of the contract.

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Bank A Bank B

At Start

$ Principal

€Principal

$ Interest

€ Interest

Illustrating a Currency Swap

$ Principal

€ Principal

At maturity

21

Application of Currency Swap

A UK company is proposing to build on behalf of a French company, a

factory in France over the next 2 years. The relevant cash flows are

outlined as follows:Year Item Cash Flow

0 purchase of land €32m

1 cost of material, labor, etc. € 50m

1 receipt of first installment from the French company € 51m

2 construction costs € 54m

2 receipt of final installment from the French company € 117m

The corporate treasurer of the UK company has been looking

at ways to hedge the currency risk on the € cash flows and has

been offered the following currency swap by the bank: A

fixed rate -fixed rate £20m currency swap at a rate of € 1.6/L

for 2 years. Interest at 7% per annum is payable in € to the

bank.

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Application of Currency Swap Any currency risk not covered by the currency swap would be

covered using a forward contract, the rate of which are as follows:

€ /£

spot rate 1.5125 －1.5250 1 year forward 16 5/8 －17 3/4 centimes discount 2 year forward 30 1/8 －31 1/4 centimes discount

Required: Calculate the amount and timing of the sterling cash flow that

will arise if currency risk is hedged using the currency swap and forward foreign exchange contracts.

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Forward Rate spot rate 1.5125 －1.5250

1 year forward 16 5/8 －17 3/4 centimes discount

2 year forward 30 1/8 －31 1/4 centimes discount

1 year forward: 1.5125 1.5250

+ 0.16625 0.1775

1.67875 1.7025

2 year forward: 1.5125 1.5250

+ 0.30125 0.3125

1.81375 1.8375

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€ Cash Flow Analysis Time Project Swap Net Flow

0 - €32m €32m 0

1 €51m－ €50m - € 32m ×7%

( €1m ) (-2.24m) - €1.24m

2 €117m－ €54m -2.24m-32m

(€63m) (-34.24m) € 28.76m

_____________________________________________

Buy €1.24m 1 year forward @ 1.68075 to lock in future pound

cost today.

Sell € 28.76m 2 years forward @ 1.8375 to lock in pound

proceed today

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Currency Swap vs Forex Swap

Exchange rate

Steps

Maturity

Principal amount

Markets involved

Origin

purpose

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New Issue Arbitrage

SwFr bond US$ bond

A 6.5% 4%

B 7% 51/4%

Differential 50bps 125bps

A wants to raise SwFr, and seeks a reduction in the cost of borrowing 5 yearSwFr at 6%pa;

B wants to raise US$ and seeks a reduction in the cost of borrowing 5 yearUS$ at 51/8%

Required : show how both A & B use a swap transaction to achieve theirobjectives.

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Reuters TeleratesFive year basis conversion factors

£ Yen DM SwFr C$ A$

US$ 1.102 0.971 1.007 1.086 1.066 1.109

£ 0.850 0.922 0.855 0.933 0.971

Yen 1.084 1.006 1.098 1.142

DM 0.928 1.013 1.053

Sw Fr 1.091 1.135

C$ 1.040

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New Issue Arbitrage

A B

$ Bond

Market

Bonds $100m

$

interest

4%

SwFr Bond

Market

Bonds SwFr

135m

SwFr

intere

st 7%

SwFr135m

$100m

SwFr interest 6%

$ interest4%

A’s Cost:SwFr6% B’s cost:$4%+SwFr1%

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Basis Conversion Factor

B’s cost:$4%+SwFr1%=?

US$1% = SwFr 1.086%

SwFr1% = US$1/1.086%= US$0.92%

B’s cost:$4%+SwFr1%=US$4.92%

( < 5 1/8%)

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Interest Rate Swap

Fixed-for-float interest rate swap

- Only the interest is swapped

Cross currency coupon swap

- Both interest and principal are swapped

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Interest Rate Swap

A B

AAA BBB

Fixed rate: 11.5% 14%

Floating rate: LIBOR LIBOR +1%

Now, A wants to borrow floating rate loan of $5m, and Bwants to borrow fixed rate loan of $5m.

Suppose A is familiar with B, how do you suggest them useinterest rate swap to achieve their objectives?

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Interest Rate Swap Structure between A&B

A

Bank1

11.5% $5m

Project

$5m $5m

Project

B

$5mLIBOR+1%

11.5%<Fixed<13%

LIBOR

12.25%

Bank2

A’s cost:

Pay : 11.5%

LIBOR

Receive:12.25%

Cost:LIBOR-0.75%

B’s cost:

Pay : LIBOR+1%

12.25%

Receive:LIBOR

cost:13.25%

Save 0.75%Save 0.75%

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3 Steps of Interest Rate Swap

Initial exchange of notional principal

Periodic payment of interest

Re-exchange of notional principal

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Purposes of Interest Rate Swap

Hedging interest rate risk

Reducing financing cost

Capital market arbitrage

Quality CompanyChoice of 9% fixed

or LIBOR + .5%Prefers variable

Risky CompanyChoice of 10.5% fixed

or LIBOR + 1%Prefers fixed

Investors in Variable Rate

Bonds Issued by Risky Company

Variable RatePayments atLIBOR+1%

Investors inFixed Rate Bonds

Issued byQuality Company

Fixed RatePayments

at 9%

Variable RatePayments atLIBOR+.5%

Fixed RatePayments at

9.5%

Illustration of An Interest Rate Swap

Gains ½ % Saves ½ %

36


An American company needs pound floating rate loan, but only euro fixed rate loan is available to it

Cross currency coupon swap

37


US company

Bank1

€ Fixed Rate

Bank2

€principal

£

£ float rate

Project in Britain

£ profit

€ principal

€ principal

Fund raising

Project Investment

Cross currency

coupon swap

€ Fixed Rate

£ principal

€principal

£ principal

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Basis Swap

Float-to-float rate swap

Major floating rates

- UK: LIBOR

- US:NYIBOR

- Australia:BBR

- China:SHIBOR

- Hongkong:HIBOR

- Singapore:SIBOR

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Bank’s Role in Swap Transactions

Arranger Merchant bank

Investment bank

Arrangement fee No risks

Assignment broker Merchant bank

Investment bank Dealing spread

Temporary credit risk & market risk

Market maker

Commercial bank

Dealing spread

Permanent credit risk & temporary

market risk

Matched book dealer

Commercial bank Arrangement fee & dealing spread

Permanent credit risk & no market

risk

40

Banks Risks in Swap Transactions

Market risk

Mismatch risk

Credit risk

Sovereign risk

Liquidity risk

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Bond Basis vs Money Market Basis

Bond Rate X 360/365 = Money Market Rate

10% interest on a bond basis on $1m for one year( non-business day ignored):

- 0.10 x 1,000,000 x 360/360= $100,000

10% interest on a money market basis on $1m for one year:

- 0.10 x 1,000,000 x 365/360= $101,389

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Day Count Conversions

Original Day Count

Days 360 365

Day Equivalent Basis

360 8.0000% 7.8904%

365 8.1111% 8.0000%

Yield Calculation Convention(2)US Dollar Payment

FrequencyCompounding Number of days

Prime 365/360

US$ LIBOR 365/360

US T-bill 365/360

US T-bonds S/A S/A 365/365

Eurodollar Bond A A 360/360

Yankee Bonds S/A S/A 360/360

Swaps S/A S/A 360/360

Yield Calculation Convention(2)Swiss Franc Payment

FrequencyCompounding Number of

Contracts

SwFr LIBOR 365/360

Foreign Bonds (Public Issue)

A A 360/360

Foreign Notes (Private Placement)

A A 360/360

Domestic Government Bonds

A A 360/360

Swaps A A 360/360

Yield Calculation Convention(3)Pound Sterling Payment


Contracts

Sterling LIBOR 365/365

Guilt Edged Securities S/A S/A 365/365

Bulldog Bonds S/A S/A 365/365

Eurosterling Bonds A A 360/360


Yield Calculation Convention(4)Japanese Yen Payment


Contracts

Yen LIBOR 365/360

Domestic Government Coupon Bond

S/A A 363/365

Samurai Bond S/A A 365/365

Euroyen Bond A A 360/360


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Equity Swap

Investor Bank

Increase in FTSE100 +10bp

Decrease in FTSE100-10bp

Note ：Inverse relationship between stock price and

interest rate.

6 months LIBOR

49

Fixed

income

portfolio

InvestorSwap

dealer

Fixed for equity Swap

Interest income

Index return

Interest rate %

• converts fixed income to equity return

- Gain equity exposure at lower cost than cash transactions

- Guarantees index outperformance if fixed income exceeds swap coupon

Stock

portfolio InvestorSwap

dealer

Equity for Floating Swap

Stock return Index return

Floating rate %

• Swaps stock portfolio return for floating rate

- Floating rate typically LIBOR based

• Index return:

- S&P 500, Nikkei 225, Dax, FT-SE100

Stock

portfolioInvestor

Swap

dealer

Equity for Fixed Swap

Stock return Index return

Fixed rate %

• Swaps stock portfolio return for fixed income

-Hedges a stock portfolio for the tenor of the swap

-Alternative to selling index futures or shorting stock

- Floating rate typically LIBOR based

• Index return:

- S&P 500, Nikkei 225, Dax, FT-SE100

Equity swap payer Typical user: stock portfolio manager

Application: hedging

Advantages:

- Avoids restrictions of shorting stocks

- Lower cost than cash transactions (borrowing stock to short)

- Avoids cost of rolling futures

Expectation: bearish stock market, interest rate falling:

- Strategy: equity for fixed

Expectation: bearish stock market, interest rate rising:

- Equity for floating

53

Equity Swap Receiver

More natural equity receivers than payers:

- Passive index funds

- Hedge funds

- Pension funds

- Insurance companies

- Mutual funds

54

Rationale for equity swaps

Cost advantages

Tax advantanges

Leverage

Restrictions on investment

ASwap

dealer

Chooser Swaps

Max[ S&P, Nikkei]

coupon

• Equity return pegged to greater of the two indices

• Higher swap coupon

ASwap

dealer

Outperformance Swaps

Nikkei

S&P

• Two equity legs

• Applications:

- Take view on relative performance of equity markets

- Change stock portfolio from one equity market to another

US Stock portfolio

ASwap

dealer

Rainbow Swaps

0.5 S&P+ 0.5Nikkei

Coupon

• Equity leg combines returns from several indices

• Used for hedging aggregate equity portfolios

US portfolio

Japan portfolio

58

San Francisco

Technology

Chicago Risk

Management

Detroit

Industrial

Payment from Detroit

Industrial Bank’s $50m

loan Portfolio

Payments from San

Francisco Technology

Bank’s $50m loan

portfolio

Loan Portfolio Swap

59

San Francisco

Technology

Chicago Risk

Management

Minneapolis

Mutual

Floating rate

Fixed rate

Total Return Swap

Fixed rate

Floating rate

Mechanics of Credit Default Swaps

Synthetic transfer of credit risk

If Credit Event: Defaulted Obligation

Credit Risk Transfer

Protection Seller

Protection Buyer

x bps p.a.

If Credit Event: Par Amount

If no credit event occurs, the only cash flow is the premiumpaid by the buyer to the seller.

If a credit event occurs, the premium payments stop and the transaction is settled either physically or via cash.

CDS Calculator on Bloomberg (CDSW page)

Par CDS

Spread Curve

62

Commodity Swaps

Fixed-for-floating commodity price swap

Commodity price-for-interest swap

Commodities:

-Precious metals:gold, silver etc,

-Base metals:copper, aluminum etc,

-Agricultural products: wheat etc

-Crude oil,refined oil products,gas etc

63

Commodity swaps---oil producer

Swap dealer Oil producer Oil user

oil

Floating price

Fixed price

Floating price

64

Commodity swaps---oil user

Swap dealer Oil user Oil producer

oilFixed price

Floating price Floating price

65

Other External Techniques

Discounting

Factoring

Forfeiting etc

topic 9 transaction exposure management (3)840145.72116.30la.com.cn/wenjian/8transaction exposure...

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