Swaps and Interest Rate Derivatives
International Corporate Finance
P.V. Viswanath
For use with Alan Shapiro “Multinational
Financial Management”
P.V. Viswanath
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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 IBM’s credit risk,
Citibank has a NPV > 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 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%. Merrill
pays 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 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)/(1+0.072(182/360)) =
$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.
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