Intrate Swaps

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Swaps and Interest Rate Derivatives

International Corporate Finance

P.V. Viswanath

For use with Alan Shapiro Multinational

Financial Management


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Learning Objectives

To describe how interest rate and currency swapsworks 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 hedgeinterest rate risk.

To explain the nature and pricing of structurednotes.


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Interest Rate Swaps

Agreement between two parties to exchange dollar interestpayments for a specific maturity on an agreed upon notionalprincipal amount. No principal changes hands.

In a coupon swap, one party pays a fixed rate calculated atthe time of the trade and the other side pays a floating ratethat resets periodically against a designated index.

In a basis swap, two parties exchange floating interestpayments based on difference reference rates.

The most important reference rate is LIBOR (LondonInterbank Offered Rate) the average interest rate offered

by a group of international banks in London for US dollardeposits of a stated maturity.


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Coupon Swaps

Counterparties A and B both require $100 m. for a 5-yr period. Awants 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 borrowfixed or floating at a good rate.

There is an opportunity for profitable exchange because the

differences in the fixed rates across counterparties is different fromthe differences in floating rates.

If A borrows floating and B borrows fixed and they swap, both arebetter off, as long as A pays B a consideration of between 50 and 100bps; in the next example, A pays B 75 bps, and 10 bps to an

intermediary.


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Numerical Example of Coupon Swap

IBM issues a 2-year floating-rate bond, principal $100m. atLIBOR6 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 forLIBOR6.

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 holdin return for the spread between a fixed 8% rate and a floatingLIBOR6 - 50 bps. If this spread is large, given IBMs credit risk,

Citibank has a NPV > 0 transaction.


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Numerical Example of Coupon Swap



Currency Swaps

A currency swap is an exchange of debt-service obligationsdenominated 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 presentvalue 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 anynonpayment by the other party with a comparable nonpayment.

In an interest rate swap, there is no need for a swap ofprincipals, whereas this usually does occur in a currency swap.



Currency Swaps



Currency Swaps: An example

Dow Chemical and Michelin both want to borrow $200m. infixed 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 at8.1%.

Both companies have similar credit risks. This means that ifDow wants to borrow in euros and Michelin in dollars, theycould simply swap payments, so that Dow gets a euro

borrowing rate of 8.1%, while Michelin gets a dollarborrowing rate of 7.5%.

Assuming a current spot rate of 1.1/$, we can compute thepayments between the two parties.



Currency Swaps: An example



Interest Rate/Currency Swaps

We can combine interest rate swaps and currency swaps.

Suppose Dow wishes to borrow euros, as before, but at afloating rate.

Dow can borrow euros at LIBOR + 0.35%, whereasMichelin can borrow at LIBOR + 0.125%

In this case, Dow will borrow fixed dollars and; Michelinwill borrow floating euros.

Dow will make floating euro payments to Michelin, while

Michelin will make fixed dollar payments to Dow to enableeach party to meet their interest rate commitments.

If they simply swap the payments, Dow will save 0.175% ininterest costs, while Michelin, as before, will save 0.20%



Interest Rate/Currency Swaps



Interest Rate/Currency Swap

Kodak wishes to raise $75m. in 5 yr. fixed rate funds.

Kodak issues an A$200m. zero-coupon bond issue at a net price of 53,which realizes A$106m.

Merrill enters into a swap agreement with bank A to swap A$70m. in

5 years at a forward rate of $0.5286/A$1. 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%. Merrillpays the bank A$68m. today and gets A$130 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 enteringinto a $ fixed/floating swap with a notional value of $48m.


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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 privateinformation 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 newinformation, the market will realize this in six months.

One way to avoid committing itself to paying high interest rates for tenyears, would be to issue short term debt; however, this would exposethe firm to interest rate risk.

It could issue short term debt right away, say at LIBOR + 100 bp andsimultaneously do a fixed-for-floating swap. Then, in six monthstime, it could issue a 9.5 year floating rate issue at a lower spread, sayat 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 ratesare 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 interestrate today on a future loan.

A forward rate agreement separates the actual loan from the interestrate risk. It is equivalent to a forward forward, where the contract is

cancelled at the date that the loan is to be initiated, and paymentsare made to make the losing party whole. Also, the risk of changesin borrower default risk are borne by the borrower.

Suppose Unilever has an agreement to borrow $50m. in 2 months fora 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 theagreement, it need pay 0.065($50m)(182/360) = $1.64m only.

Hence there is a saving of (1.82-1.64)/(1+0.072(182/360)) =

$0.17073m.


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Eurodollar futures

Eurodollar futures are cash-settled futures contracts on athree-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-marketonly when the contract matures.

Furthermore, the notional value of an FRA is the amount to

be borrowed, while the notional value in a eurodollarfutures 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 indexnumber equal to 100 minus the annualized forward interestrate. If the current futures price is 91.68, the value of thiscontract 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 buyergets 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 inthe future would sell a Eurodollar futures contract; oneintending to lend money would buy.


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Structured Notes

Interest bearing securities whose interest payments aredetermined by reference to a formula set in advance andadjusted 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 taxreasons, an investor might want to front-load his interest income.

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Intrate Swaps