Managing Interest Rate Risk with Cross Currency Swaps Saniye Atak Chintan Shah Eddie Warner

NYU-SCPS. Interest Rate Swaps. X51.9204

26 July 2010

• • • •

Some Tools to Manage Interest Rate Risk

Refinancing – go back to lender and restructure/refinance the agreement. Not always possible and usually expensive.

Forward Rate Agreement – lock in future interest rate payment. OTC market.

Interest Rate Futures – lock in future interest rate payments by taking a position in an interest rate futures position.

Interest Rate Swaps – enter into an agreement with a bank or swap-dealer to exchange cash flows in such a way that interest rate payments on a floating loan would become fixed.

Cross Currency Swaps

• An agreement between two counterparties to exchange future cash flows.

– Cross Currency Swap involves the exchange of cash flows from one currency for those in another with an agreement to reverse that transaction at a future date.

– Interest Rate swaps changes the basis on which income streams or liabilities are received or paid on a specified principal amount.

Cross Currency Swaps

• • • • • Two cash-flow schedules in different currencies.

Two notional amounts in different currencies.

Motivation to enter in a cross currency swap is the desire to pay interest in a currency with lower rates such as JPY or CHF and receive interest in a currency with higher rates.

Gives companies extra flexibility to exploit their comparative advantage in their respective borrowing markets.

Allows companies to explain advantages across a matrix of currencies and maturities.

Cross Currency Swaps

• • Advantages – Beneficial interest rate payments, i.e. receiving higher coupons or paying lower coupons than market – Liquid and transparent product – – Zero/Low cost product (Partial) protection of the notional possible Disadvantages – Long term FX forward risk – Long term view on the FX rate impossible

Structure of a Cross Currency Swap

• • • • Exchange notional amounts at inception – Use current spot rate (CHF = Swiss Francs) – $10m USD at 1.1138 CHF, Sfr 11.138m

Pay/Receive intermediate cash flows – Use bid/ask swap rates Re-exchange notional amounts at expiration – Using agreed upon spot rate, 1.1138 CHF CHF stands for Confoederatio Helvetica Franc

Initial Exchange of Notional

Pay/Receive Intermediate Cash Flows

Re-exchange notional at expiration

Cross Currency Swap Case Study

• • Carlton Corporation – Recently took out a 3Y floating-rate loan for $10M – Was worried interest rates would rise – Used an Interest Rate Swap to convert to fixed Carlton recently signed a contract with a Swiss buyer that will be paying Francs to Carlton – Incoming Swiss Francs cash flows – Good motivation for Cross Currency Swap

Interest Rate and Currency Swap Quotes

Years

1 2 3 4 5 6 7 8 9 10 12 15 20 25 30

LIBOR Bid Euro - € Ask

2.99

3.08

3.24

3.44

3.63

3.83

4.01

4.18

4.32

4.42

4.58

4.75

5.00

5.13

5.19

3.02

3.12

3.28

3.48

3.67

3.87

4.05

4.22

4.36

4.46

4.62

4.82

5.04

5.17

5.23

3.0313

3.0938

Swiss Franc - Sfr Bid Ask

1.43

1.68

1.93

2.15

2.35

2.54

2.73

2.91

3.08

3.22

3.45

3.71

3.96

4.07

4.16

1.47

1.76

2.01

2.23

2.43

2.62

2.81

2.99

3.16

3.30

3.55

3.81

4.06

1.17

4.26

1.3125

1.4375

US Dollar $ Bid Ask

5.24

5.43

5.56

5.65

5.73

5.80

5.86

5.92

5.96

6.01

6.10

6.20

6.29

6.29

6.28

5.27

5.46

5.59

5.68

5.76

5.83

5.89

5.95

5.99

6.04

6.13

6.23

6.32

6.32

6.31

4.9373

5.0625

Japanese Yen - ¥ Bid Ask

0.23

0.36

0.56

0.82

1.09

1.33

1.55

1.75

1.90

2.04

2.28

2.51

2.71

2.77

2.82

0.26

0.39

0.59

0.85

1.12

1.36

1.58

1.78

1.93

2.07

2.32

2.56

2.76

2.82

2.88

0.1250

0.2188

Setting up the Cross Currency Swap

• • • Carlton enters into a three-year receive US

Dollars and pay Swiss francs.

– Carlton pays 3Y CHF Ask rate (2.01%) – Carlton receives 3Y USD Bid rate (5.56%) Target currency is CHF. $10M = 11.138M Sfr – Interest Payment: 2.01% × 11.138M Sfr = 223,873.80 Sfr Receiving currency is USD.

– Interest Received: 5.56% × 10M = $556,000

Pay CHF & Receive USD

• • • • Accounting practices will require mark-to-market If CHF appreciates, Carlton would record a loss.

If CHF interest rates were rising, Carlton committed to a fixed 2.01% and would record a gain.

P&L will persist over course of swaps life.

How to price a currency swap swap with SWPM

• SWPM is the main interest rate derivatives pricing function in the Bloomberg professional system, allowing users to price a wide range of vanilla and exotic interest rate swaps, interest rate options, swaptions and interest rate / hybrid structured notes.

• We will use SWPM to price a cross currency interest rate swap transaction and calculate a mark to market price with current markets or historicized curves.

Example

Receive 4.5% on 10MM USD and pay floating Euribor 3M Notional Effective Date Maturity User receives Pay frequency Day Count Business days adj. User pays Euribor Pay frequency Day Count 10MM USD 6/29/2010 6/29/2015 4.50% p.a

SemiAnnual 30/360 unadjusted 3M flat Quaterly act/360

To have a quick price of a new Interest Rate Swap transaction user has to - open SWPM; - enter the IRS details in the Main Screen relevant input fields; - select Calculate Premium from Calculate menu field; - refresh for price

In Curves Screen user can: - visualize and export in Excel the par or zero coupon curve used for swap evaluation; - manually override curve values; - apply shifts to the whole curve or to defined buckets; - choose interpolation method used;

Use the Cashflow Screen to visualize and export to an Excel spreadsheet deal cash flows, with the ability to choose between Net, Pay, Receive and Historical cash flows.

The Risk Screen shows for each leg some key risk measures : - DV01: the dollar value of a 1-basis-point negative shift in the curve.

- Risk: the risk for each leg and the deal is calculated according to the following equations: Risk = [DV01 / Notional] x 10,000