Chapter Nine

1
Chapter Nine

• Types of Swaps
• Interest Rate Swaps
• Currency Swaps
• Variations of Currency and Interest Rate Swaps
• Risks of Interest Rate and Currency Swaps
• Concluding Points About Swaps

2
Definitions

• In a swap, two counterparties agree to exchange
  or swap cash flows at periodic intervals.
• There are two types of swaps
• Interest rate swap an exchange of fixed-rate
  interest payments for floating-rate interest
  payments.
• Currency swap an exchange of interest payments
  in one currency for interest payments in another
  currency.

3
An Example of an Interest Rate Swap

• Washington Mutual has a huge portfolio of
  fixed-rate mortgages (averaging 13.25) financed
  by deposits earning a floating-rate of interest
  (currently paying LIBOR 1).
• Income fixed.
• Obligations floating.
• What is WAMU afraid of?

4
An Example of an Interest Rate Swap

• Westcoast Finance provides short-term loans to
  companies throughout the West (currently charging
  LIBOR .75) and is financed by a 30-year
  fixed-rate bond issue made 4 years ago (paying
  11).
• Income floating.
• Obligations fixed.
• What is Westcoast afraid of?

5
An Example of an Interest Rate Swap
Swap Bank
LIBOR
11.75
WAMU
The swap bank makes this offer to WAMU You pay
11.75 per year on 10 million notional value
for 5 years and we will pay you LIBOR on 10
million for 5 years
6
An Example of an Interest Rate Swap
Swap Bank
Heres whats in it for WAMU
LIBOR
LIBOR1
11.75
WAMU
They borrow LIBOR 1 floating and have a net
borrowing position of 13.25 LIBOR (11.75
LIBOR 1) 0.50
13.25
0.50 of 10,000,000 50,000 per year for 5
years.
7
An Example of an Interest Rate Swap
Swap Bank
LIBOR
11.25
Westcoast
The swap bank makes this offer to Westcoast You
pay us LIBOR per year on 10 million for 5 years
and we will pay you 11.25 per year on 10
million for 5 years.
8
An Example of an Interest Rate Swap
Swap Bank
Heres whats in it for Westcoast
LIBOR
11.25
11
Westcoast
They borrow at 11 and have a net borrowing
position of (LIBOR .75 11.25) - (LIBOR
11) 1.00
LIBOR .75
1 of 10,000,000 100,000 per year for 5
years.
9
An Example of an Interest Rate Swap
The swap bank makes money too
Swap Bank
LIBOR
LIBOR
11.25
11.75
WAMU
Westcoast
(LIBOR LIBOR) (11.75 11.25) 0.50
0.5 of 10 million 50,000 per year for 5
years.
10
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, WAMU is less credit-worthy
  than Westcoast, which is why they got less of the
  QSD, compensating the swap bank for WAMUs higher
  default risk.

11
An Example of an Interest Rate Swap

• The borrowing opportunities of the two firms are
  shown in the following table

12
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 dollars for pounds.
• This will give them exchange rate risk How?
• They could borrow pounds in the international
  bond market, but pay a relatively higher rate
  since they are not as well known abroad.

13
An Example of a Currency Swap

• If they can find a British MNC with a
  mirror-image financing need, each firm may
  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.

14
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
  others country of the same size. Their borrowing
  opportunities are given in the table below.

15
An Example of a Currency Swap
Swap Bank
9.4
8
12
11
Company B
Company A
12
8
16
An Example of a Currency Swap
Swap Bank
9.4
8
12
11
Company B
Company A
12
8
As net position is to borrow at 11
A saves .6
17
An Example of a Currency Swap
Swap Bank
9.4
8
12
11
Company B
Company A
12
8
Bs net position is to borrow at 9.4
B saves .6
18
An Example of a Currency Swap
Receives 1.4 of 16m, pays out 1 of 10m per
year for 5 years.
The swap bank makes money too
Swap Bank
9.4
8
12
11
Company B
Company A
12
8
At S0(/) 1.60/, that is a gain of 64,000
per year for 5 years.
However, the swap bank faces exchange rate risk.
HOW? But it may be able to lay it off in another
swap.
19
Comparative Advantage as the Basis for Swaps

• 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.

20
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/Index 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.

21
Risks of Interest Rate and Currency Swaps
(continued)

• Credit Risk
• This is the major risk faced by a swap dealerthe
  risk that a counter party will default on its end
  of the swap.
• Mismatch Risk
• Its 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.

22
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
• For a swap to be possible, a QSD must exist.
  Beyond that, creativity is the only limit.