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SWAPS
• The Short-Term Currency Swap
An illustration:
Bank of England (BoE) wants to borrow USD from the
Bundesbank (Buba). Buba asks, as security, an equivalent amount
of GBP (to be deposited by the BoE with the Buba). Barring
default, on the expiration day the USD and the GBP would each
be returned, with interest, to the respective owners
Example
S = USD/GBP 2.5, r$ = 3%, r£ = 5%.
time t: BoE receives USD 100m from the Buba for six months,
deposits GBP 100m/2.5 = GBP 40m into an escrow account
with the Buba.
time T: the Buba returns GBP 40m ¥ 1.05 = 42m, and the BoE
returns USD 100m ¥ 1.03 = USD 103m
SWAPS
• Two ways to view the traditional short-time swap contract
View 1: two mutual loan contracts, one for USD 100m to the Bank
of England, and the other for GBP 40m to the Bundesbank, with a
right-of-offset clause linking the two loans.
“if one party fails to fulfill its obligations, then the other
party is exonerated from its normal obligations too, and can sue
the defaulting party if any losses occur”
The Short-Term Currency Swap
USD loan [BB—>BE]
At time t:
GBP loan [BB—>BE]
BB transfers USD 100m BE transfers GBP 40m
to BE
to BB
At time T: BE transfers USD 103m BB transfers GBP 42m
to BB
to BE
spot sale of
USD 100m to BE
at St = USD/GBP 2.5
forward purchase of
USD 103m from BE
at Ft,T = 2.39535
Total: swap contract
SWAPS
• Two ways to view the traditional short-time swap contract
View 2: a spot sale by the Bundesbank of USD 100m for GBP,
combined with a six month forward purchase of USD 103m at
103/42 = 2.45238 = USD/GBP 2.5 ¥ 1.03/1.05 = F.
SWAPS
• Why short-term Swaps exist?
1. Safety
2. Reduction of Transaction Costs
3. Tax Avoidance
4. Religious objections against interest
5. Fictitious Transactions
SWAPS
• Why short-term Swaps exist? (cont.)
1. Safety:
Example
Repurchase order (repo): an investor in need of short-term financing
sells low-risk assets (like T-bills) to a lender, and buys them back
under a short-term forward contract
Low-risk loan fi low bid-ask spread ('haircut')
SWAPS
• Why short-term Swaps exist? (cont.)
2. Reduction of transaction costs:
If an investor intends to reverse the transaction
Example
A French investor is optimistic about $ returns on US stocks,
but not about the $ itself. She buys spot USD to invest in US stocks,
and sells USD forward to hedge the $ risk
SWAPS
• Why short-term Swaps exist? (cont.)
3. Tax Avoidance:
When capital gains are taxed at a lower rate
Example
Buy 10 kilos of gold from a bank at the spot price St = LUF 5m
and sell it back (forward) at Ft,T = St (1+rt,T) = 5.25m
This is a disguised deposit of LUF 5m at 5%, but the return is
a capital gain
SWAPS
• Why short-term Swaps exist? (cont.)
4. Religious objections against interest: Catholic Church, Islam
5. Fictitious transactions:
• Hide losses by selling assets at inflated prices (and buy them
back at similarly inflated forward prices)
• Hide the ownership of assets by conjuring them away
around the reporting date
SWAPS
• Back-to-Back and Parallel Loans
The right-of-offset was already used in back-to-back and parallel loans
Back-to-back loans:
UK institutional investor (UKII) wants to invest in US. But “investment
dollar premium” made foreign investments expensive to UK
investors. Thus, UKII wants to avoid the spot market at t and T,
by setting up a deal with a foreign firm (USCo) that wants to
invest in the UK:
• USCo lends USD to UKII
• UKII lends GBP to USCo (or its UK subsidiary)
Right of offset between these two loan contracts: if (say) UKII
cannot pay back, USCo can withhold its payments and sue
for the net loss (if any)
SWAPS
Back-to-back loans: (cont.)
Flow of initial principals under a back-t o-back loan
USD cap mkt
USCo
USD
UKII
USCo's SU BS
GBP
SWAPS
Parallel loans:
• USCo faces capital export controls, cannot export USD to its
UK subsidiary
• UKCo wants to lend to its US subsidiary, but there is a
dollar premium
• Both can avoid the spot market by granting loans to each
other (or to each other’s subsidiary), with a right of offset
in the two loan contracts
T he initial flows of principal under a parallel loan
UK Co's SUBS
USD
USCo
UKCo
GBP
USCo's SU BS
SWAPS
• The 1981 IBM/World Bank Currency Swap:
IBM wanted to call its DEM- and CHF debt: the USD had
appreciated considerably and the DEM and CHF interest
rates had also gone up. But this would be costly:
• Exchange transaction costs when IBM buys DEM and CHF
• Call premium: IBM has to pay more than the DEM and
CHF face value
• Issuing costs when IBM issues new USD bonds.
• Capital gains taxes on realized gain
SWAPS
• The 1981 IBM/World Bank Currency Swap:(cont.)
The World Bank (WB) wanted to borrow DEM and CHF to lend
to its own customers
• issuing costs on new CHF and DEM bonds
Note that IBM wants to withdraw CHF and DEM bonds (at a rather high
cost) while WB wants to issue CHF and DEM bonds (also at a cost). To
avoid most of these costs, IBM and WB agreed that WB would take
over IBM’s foreign debt instead
SWAPS
• The 1981 IBM/World Bank Currency Swap:(cont.)
Specifically,
• WB borrows USD instead of DEM, CHF. With the proceeds it buys
spot CHF and DEM for its loans
• WB undertakes to deliver to IBM the DEM and CHF necessary
to service IBM’s old DEM and CHF loans,
... while IBM promised to provide the WB with the USD needed
to service the WB's (new) USD loan;
SWAPS
• The 1981 IBM/World Bank Currency Swap:(cont.)
Right of offset between the undertakings
USD service
IBM
WB
DEM & CHF service
DEM & CHF
DEM & CHF
bondholders
USD
USD Eurobond
holders
Equal initial value principle: the present value of IBM's (USD)
payments to the WB is equal to the present value of the (DEM
and CHF) inflows received from the WB.
SWAPS
• The 1981 IBM/World Bank Currency Swap:(cont.)
Example
• IBM’s DEM debt is DEM 10m at 5% maturing within 5 years
• The current 5-year DEM interest rate is 10% and
St = USD/DEM 0.4
• Market value of service payments:
(1)
DEM 10m ¥ [1 + (.05 - .1) ¥ a(10 %, 5 years)]
= DEM 8.105m
or 8.105 ¥ .4 = USD 3.242m. So the USD loan should also be
worth USD 3.242m.
SWAPS
• The Fixed-for-Fixed Currency Swap
First review the short-term swap:
the contract has zero initial value
• The spot and forward contracts each have zero value because
the amounts are exchanged at the going spot and forward rate
• Also in the “mutual loan” view, zero initial value holds
[example (Buba/BoE): 5% on GBP, 3% on USD, St=2.5]:
PVUSD = = USD 100 ; and
PVGBP = = GBP 40, or USD 100
SWAPS
• The Fixed-for-Fixed Currency Swap (cont.)
the rates used for setting the forward rate or, equivalently,
for discounting the promised payments are the (near-riskless)
short-term interbank rates:
• default risk is limited by the forward contract’s right-of-offset
• remaining risks are largely eliminated by screening of
the customers, and by margins or other pledges
SWAPS
Characteristics of the Modern Currency Swap
Definition. Two parties agree to:
• exchange, at time t, two initially equivalent principals
denominated in different currencies
• return these principals to each other at T
• pay the normal interest, periodically, to each other on the
amounts borrowed
SWAPS
Characteristics of the Modern Currency Swap (cont.)
The deal is structured as one single contract, with a right of offset
Example
Initial exchange of principals
annual interest payments
payment of principal at T
Leg 1 (DEM)
18m at 8%
(“lent”)
leg 2 (USD)
10m at 7%
(“borrowed”)
<DEM 18.0m>
DEM 1.44m
DEM 18.0m
USD 10.0m
<USD 0.7m>
<USD10.0m>
SWAPS
Characteristics of the Modern Currency Swap (cont.)
Swap rates The interest payments for each currency are based
on the currency's "swap (interest) rate"—yields at par for
near-riskless bonds with the same maturity as the swap
Why riskfree rates?
right-of-offset clause; sometimes margin is posted probability
f default is small: screening, 'credit trigger' the uncertainty
about the bank’s inflows is the same as the uncertainty
about the bank’s outflow side. Thus, the corrections for
(minute) risk virtually cancel out
SWAPS
Characteristics of the Modern Currency Swap (cont.)
Zero Initial value The initial exchange of principals is a
zero-value transaction because the amounts are initially
equivalent. The future interest payments and amortization
have equal present values, too
Example
(2) PVUSD = + = USD 10m,
(3) PVDEM = + = DEM 18m
which implies that the PV in USD is 18m/1.8 = USD 10m
SWAPS
Characteristics of the Modern Currency Swap (cont.)
Costs A commission of, say, USD 500 on a USD 1m swap,
for each payment to be made. Most often this fee is built into
the interest rates, which would raise or lower the quoted rate
by a few basis points
Sometimes an equivalent up-front fee is asked
Example
7-year yields at par are 7.17% on USD and 9.9% on DEM.
The swap dealer quotes:
USD 7.13% - 7.21%
DEM 9.58% - 9.95%
If your swap contract is one where you "borrow" DEM and
"lend" USD, you pay 9.95% on the DEM, and you receive
7.13% on the USD
SWAPS
•Coupon Swaps (Fixed-for-Floating)
Characteristics of the Fixed-for-Floating Swap
Example
An AA Irish company wants to borrow NZD to finance (and
partially hedge) its direct investment in New Zealand.
Better conditions in London than in Wellington preference
for fixed-rate loans, but spread on revolving bank loans is
lower than spread on fixed-rate Eurobonds:
[LIBOR+1%] vs 19% [= swap rate + 3%]
SWAPS
•Coupon Swaps (Fixed-for-Floating)
Characteristics of the Fixed-for-Floating Swap (cont.)
loan
1m at
LIBOR + 1%
t: principals
interest
T: principal
swap contract
total
1m at LIBOR 1m at 16% loan + swap
("lent")
("borrowed")
1
<1>
1
1
<LIBOR + 1%>
LIBOR
16%
<16% + 1%>
<1>
1
<1>
<1>
The company borrows NZD at the (risk-free) swap rate (16%)
plus the spread of 1% it can obtain in the "best" market (the
floating-rate Eurobank-loan market)
SWAPS
• Base Swaps
Example: IN: T-bill rate / OUT: Eurodollar (LIBOR)
Why?
• To speculate on the TED spread
• (For a swap dealer): to hedge two (unrelated) coupon
swaps—one where IN is LIBOR and OUT is T-bill
SWAPS
• Cross-Currency Swaps
Renaul t
USD
fl oati ng
YEN
fi xed
operati ng
income
Bankers
Trus t
USD
fl oati ng
Yamaichi
Securit ies
YEN
fi xed
YEN
fi xed
fl oati ng
rate note
portfol io
USD
fl oati ng
Renaul t's
USD fl oati ng
rate note
holders
Yamaichi's
Yen fixed
rate l enders
SWAPS
• Cocktail Swap
USD 1 2%
USD 1 2%
Ban k B
CHF 5%
USDLIB +.7 5%
Co A
USDLIBOR
+ .7 5 %
USD fl oati ng rate lend ers
Co D
Co C
CHF 5%
fi xed
CHF fixed rate len ders
USD 1 2%
fi xed
USD fixed rate len ders
SWAPS
• Conclusions
Swaps allow a company to
• borrow in the market where it can obtain the lowest spread
exchange the risk-free component of the loan’s service
• payments for the risk free component of a another loan
that is thought to be more suitable
most suitable loan:
fixed rate:
in the same currency:
in another currency:
original loan (with the lowest spread)
fixed rate
floating rate
-
interest rate swap
fixed-for-fixed
circus swap
currency swap
floating-rate:
in the same currency: interest rate swap
in another currency:
circus swap
floating-for-floating
currency swap
SWAPS
• Case. An Interest Rate Swap: Will it work?
Basket
Corporation
Metro Bank
Fixed Rate Payer
12% Fixed
Sushi Bank
Floating Rate Swap
Target Rates
LIBID (-)1/8%
At least 12 basis
points
B
a
s
k
e
t
Fixed Reference Rate:
- 7 year note
- All in cost 127/8%
= 12.875%
Sushi Bank can
issue 7-yr
Eurobond at 12%
B Floating Reference Rate:
a
s - Commercial
k - Paper rate + 1/2% fee
e
93/8 + 1/2% = 97/8%
t
SWAPS
• Case. An Interest Rate Swap: Will it work? (cont.)
LIBOR (overnight)
= 9%
Basis Swap
7 days
= 91/8%
CP + 1/4%
1 month
= 92/8%
Vs.
3 months
= 93/8%
LIBOR
6 months
= 95/8%
1 year
= 97/8%
Total Gain/Loss:
for basket
+ 109.5 basis points
-
50.0 basis points
+
59.5 basis points
SWAPS
• Case. An Interest Rate Swap: Will it work? (cont.)
From Sushi Bank:
Point of View:
Sushi receives reference:
11.66% ie 112/3%
1/3% loss
12%
Sushi pays:
LIBOR - 1/2%
(-) 3/8% gain
Reference:
LIBOR - 1/8%
Total Gain to Sushi Bank:
1/3 - 1/8% = 1/12%
3/8 - 1/3 = (9-8)/24 = 1/24%
SWAPS
• Case. An Interest Rate Swap: Will it work? (cont.)
Gain to Metro Bank:
12 basis points
1. Swap is successful
2. Default Risk of Counter Parties