Chapter 7 Currency Swaps

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Chapter 7Currency Swaps Swaps Markets

• Learning objectives
• ? Parallel loans A precursor to the swap
• ? Currency swaps
• Swap pricing schedules
• Fully covered swap pricing
• Hedging exposure to currency risk
• Other types of swaps
• Interest rate swaps
• Commodity swaps

Butler, Multinational Finance, 4e
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Motivation for a currency swap

• A small UK firm wants to convert floating-rate
  debt into fixed-rate debt to offset its
  revenues from US sales
• The UK firms alternatives include
• A direct issue in US dollars
• A parallel loan that trades floating-rate debt
  for the fixed-rate debt of a U.S. company

Parallel loans
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A parallel loan

• Borrow in your local currency and then trade for
  the debt of a foreign counterparty
• Parallel loans provide access to new capital
  markets
• Legally circumvent taxes on cross-border currency
  transactions
• Provide foreign-source financing for foreign
  subsidiaries
• May lower the firms cost of capital

Parallel loans
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Problems with parallel loans

• The foreign counterparty may have default risk
• Parallel loans must be capitalized on the balance
  sheet
• Search costs can be high

Parallel loans
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The swap contract

• The solution Package the parallel loans into a
  single legal agreement called the swap contract
• This reduced the default risk of parallel loans
  via the rights of set-off
• Swaps need not be capitalized on the balance
  sheet
• As volume in the swaps market rose, search costs
  were reduced and liquidity increased

Currency swaps
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Currency swapsIll pay yours if you pay mine

• Currency Swap
• An agreement to exchange a principal amount of
  two currencies and, after a pre-arranged length
  of time, re-exchange the original principal
• Interest payments are also usually swapped during
  the life of the contract

Currency swaps
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Development of the swaps market

• 1981
• Salomon Brothers engineers the first currency
  swap between the World Bank and IBM
• Early 1980s
• Customized, low-volume, high-margin deals
• Late 1980s and 1990s
• Commercial and investment banks begin to serve as
  swaps dealers
• Swaps turn into a standardized, high-volume,
  low-margin business
• Volume and liquidity grow

Currency swaps
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A note on day count conventions

• Adjusting for day count conventions
• Bond equivalent yields (BEY) are quoted as
  Actual/365
• Money market yields (MMY) are quoted as
  Actual/360
• The relation between the two is
• MMY BEY (360/365)

Currency swaps
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Example of a currency coupon swap

• Ford Motor Company (U.S.)
• Ford has 100 million in 2-year, fixed-rate
  dollar debt at 6.62 compounded semiannually (sa)
• Ford wants floating-rate Indian rupee debt
• Tata Motors (India)
• TM has Rupee 4.032 billion in 2-year,
  floating-rate rupee debt with semiannual payments
  priced at LIBOR60 bps
• TM wants fixed-rate U.S. dollar debt

Currency swaps
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Pricing schedule for a Rupee/ currency coupon
swap

• Maturity Bid () Ask ()
• 2 years 6.04 6.20
• All quotes are U.S. dollars semiannual
  actual/365 against 6-month LIBOR flat in rupees
• S0Rp/ Rp 40.3200/
• Assume yield curves are flat, and the dollar is
  selling at a six-month forward premium of 2.04

Currency swaps
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TMs uncovered swap cash flows
Currency swaps
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TMs fully covered swap cash flows
Currency swaps
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A fully covered swap(floating-to-fixed
conversion)

• 1. Convert the floating rate (MMY) spread to
  LIBOR into BEY MMY (365/360)
• 2. Find the corresponding spread in the other
  currency from equation (7.2)
• (7.2)
• 3. Calculate the fixed rate payment from the
  spread and the swap ask rate

Currency swaps
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1. Convert the floating rate (MMY) spread to
LIBOR into BEY

• TMs 30 bp spread to LIBOR is quoted as a money
  market yield (MMY)
• The bond equivalent yield is
• BEY MMY (365/360)
• (30 bps) (365/360)
• 30.4167 bps every six months
• or 60.8333 bps per year (sa)

Currency swaps
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2. Find the corresponding spread in the other
currency

• The swap mid-rate is 6.12 percent or i 3.06
  percent per six months
• The dollar is at a 6-month forward premium of
  2.04, so the 6-month rupee interest rate is
• iRp (1i)(F1Rp//S0Rp/)1
• (1.0306)(1.0204)1
• 5.162424 per six months

Currency swaps
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2. Find the corresponding spread in the other
currency

• Equation (7.2) is used to find an equivalent
  fixed rate spread in another currency
• (7.2)
• Yield curves are flat in our problem, so the
  following values are useful
• PVIFA (3.060000, 4 periods) 3.711771
• PVIFARp (5.162424, 4 periods) 3.532613

Currency swaps
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2. Find the corresponding spread in the other
currency

• TMs LIBOR spread is 30.4167 bps in rupees
• Solving equation (7.2) for the equivalent dollar
  spread r results in
• (7.2)
• or r (30.4167 bps) (3.532613 / 3.711771)
• 28.9485 bps per six months

Currency swaps
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3. Calculate the payment from the swap ask rate
and the spread

• TMs all-in cost of fixed rate dollar debt is
• 3.100000 percent (swap ask rate)
• 0.289485 percent (spread)
• r 3.389485 percent per six months
• or 6.778970 percent per year
• compounded semi-annually
• or APR (1.03389485)2 1 6.893857

Currency swaps
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Fords uncovered swap cash flows
Currency swaps
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Fords fully covered swap cash flows
Currency swaps
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A fully covered swap(fixed-to-floating
conversion)

• 1. Find the spread over the swap bid rate
• 2. Find the corresponding spread in the other
  currency from equation (7.2)
• (7.2)
• 3. Convert this BEY spread to a MMY spread over
  LIBOR

Currency swaps
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1. Calculate the spread to the swap bid rate

• Fords dollar spread to the swap bid rate is
• 3.31 percent (fixed interest rate)
• 3.02 percent (swap bid rate)
• r 0.29 percent every six months ()

Currency swaps
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2. Find the corresponding premium in the other
currency

• Solving equation (7.2) for the rupee spread rRp
  that yields the same present value as the dollar
  spread results in
• (7.2)
• or rRp (29 bps) (3.711771 / 3.532613 )
• 30.4708 bps per six months (BEY)

Currency swaps
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3. Convert the BEY spread to a floating rate MMY
spread

• Fords 30.4708 bp spread is quoted as a bond
  equivalent yield (BEY)
• The corresponding money market yield is
• MMY BEY (360/365)
• (30.4708 bps) (360/365)
• 30.0533 bps every six months
• Fords all-in cost of floating rate rupee debt
  is LIBOR 60.1067 bps (sa)

Currency swaps
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The swap banksuncovered cash flows
Currency swaps
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The swap banksfully covered cash flows
Currency swaps
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The swap banksfully covered cash flows
BEY (Rp) (0.0533 bps)(365/360) 0.0540
bps BEY () ? r BEY () 0.0515 bps, or
0.000515 Swap banks return as a dollar bond
equivalent yield 0.079485 0.000515 0.08
percent or 8 bps per six-month period
Currency swaps
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Interest rate swaps

• Interest rate swap
• Same as a currency swap, but in a single currency
• A difference check is paid during the life of the
  swap
• The principal is purely notional, and is not
  swapped

Other types of swaps
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Floating-to-fixed conversionfor an interest rate
swap

• 1. Convert the floating rate (MMY) spread to
  LIBOR into BEY MMY (365/360)
• 2. Find the corresponding spread in the other
  currency from equation (7.2)
• Step 2 is no longer necessary
• 3. Calculate the fixed rate payment from the
  spread and the swap ask rate

Currency swaps
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Fixed-to-floating conversionfor an interest rate
swap

• 1. Find the spread over the swap bid rate
• 2. Find the corresponding spread in the other
  currency from equation (7.2)
• Step 2 is no longer necessary
• 3. Convert this BEY spread to a MMY spread over
  LIBOR

Currency swaps
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Commodity swaps

• Commodity swaps are traded against a variety of
  commodity prices including
• Oil
• Gold
• Pork belly prices
• Most commodity swaps are fixed-for-floating swaps
  based upon spot prices

Other types of swaps
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An oil-for-euro swap

• A Dutch chemicals manufacturer uses 500,000
  barrels of oil every 3 months
• The manufacturer has contracted to sell its
  products at a fixed euro price for 5 years and
  wants to fix its input costs in euros as well

Other types of swaps
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An oil price swap
Spot oil market
Spot oil price
Oil
Spot oil price
Dutch firm
Commodity swap dealer
Fixed rate (s)
Other types of swaps
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An oil price swap
Spot oil market
Spot oil price
Oil
Spot oil price
Dutch firm
Commodity swap dealer
Fixed rate (s)
Fixed rate (s)
Counterparty
Interest rate swap dealer
LIBOR (s)
Other types of swaps
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An oil price swap
Spot oil market
Spot oil price
Oil
Spot oil price
Dutch firm
Commodity swap dealer
Fixed rate (s)
Fixed rate (s)
Counterparty
Interest rate swap dealer
LIBOR (s)
LIBOR (s)
Counterparty
Currency swap dealer
Fixed rate (s)
Other types of swaps
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A debt-for-equity swap

• A London bank holds a volatile portfolio of
  H-shares that is highly correlated with the Hang
  Seng China Enterprises index
• The bank decides it would rather hold fixed-rate
  pound sterling debt
• Combine the following three swaps to achieve the
  desired result
• A fixed-for-floating interest rate swap
• A pound-for-HK currency swap
• An equity swap for fixed-rate HK debt

Other types of swaps
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Swapping H-shares for debt
H-share portfolio
H-share return
H-share return
London bank
Equity swap dealer
Fixed rate (HKs)
Other types of swaps
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Swapping H-shares for debt
H-share portfolio
H-share return
H-share return
London bank
Equity swap dealer
Fixed rate (HKs)
Fixed rate (HKs)
London bank
Currency swap dealer
LIBOR (s)
Other types of swaps
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Swapping H-shares for debt
H-share portfolio
H-share return
H-share return
London bank
Equity swap dealer
Fixed rate (HKs)
Fixed rate (HKs)
London bank
Currency swap dealer
LIBOR (s)
LIBOR (s)
London bank
Interest rate swap dealer
Fixed rate (s)
Other types of swaps
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Swaptions

• A swaption is a swap with one or more options
  attached
• Interest rate ceilings or floors
• Exchange rate caps
• Multiple options (e.g. cylinder options)
• The option component of a swaption is on the
  underlying fixed-rate bond and is priced
  accordingly

Other types of swaps