Chapter 21 - Interest Rate and Foreign Currency Swaps

Chapter 21 - Interest Rate and Foreign Currency Swaps -...

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723 Interest Rate and Foreign Currency Swaps I n 2002, only 18% of Wal-Mart’s outstanding debt had payments that fluctuated with the short-term interest rate. By 2003, it had increased the exposure of its outstanding debt to short-term interest rates to more than 40% by engaging in interest rate swaps. In 2011, Chinese authorities announced that certain banks would be allowed to offer currency swaps to their corporate clients. These corporations can now issue dollar debt and swap into renminbi debt, or vice versa. This chapter examines interest rate and currency swaps, which are additional instru- ments for your risk management tool kit. We have previously discussed a number of ways of managing a firm’s currency risks using derivative securities, including forward contracts in Chapter 3 and futures and options in Chapter 20. The maturities for these instruments are somewhat limited, whereas the maturities in the swap markets extend to 30 years. We have also noted that exchange rate exposures can be thought of as arising from a general mis- match between assets and liabilities denominated in different currencies. We will see how interest rate swaps allow firms to change the nature of their liabilities for a given currency from fixed to floating interest rates or from floating to fixed interest rates. Currency swaps can be used to change the currency of denomination of a firm’s liabilities. Changes such as these can be desirable as the nature of a firm’s business changes. Swaps also allow firms to seek out low-cost financing without sacrificing their preferred type of debt. Section 21.1 introduces the basic ideas associated with swaps and discusses the impres- sive size of the swap market. Section 21.2 provides a detailed analysis of the cash flows of interest rate swaps, and Section 21.3 provides a detailed analysis of the cash flows of currency swaps. 21.1 I NTRODUCTION TO S WAPS Swaps are agreements between two counterparties to exchange a sequence of cash flows. In the modern swap market, over-the-counter dealers at major banks quote bid–ask spreads at which they are willing to do either side of a swap. The cash flows of interest rate and currency swaps are structured like the cash flows of standard bonds, and the maturities extend from 1 year to 30 years and even more. Many international financial managers now actively use swaps to manage their companies’ interest rate and currency risks and for speculative purposes. 21 21 Chapter Chapter
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724 Part V Foreign Currency Derivatives The nature of the contract between swap counterparties is usually based on the best practices suggested by the International Swaps and Derivatives Association (ISDA) . The ISDA is a trade organization that was chartered in 1985 and now represents more than 800 member institutions from 56 countries. Its members include most of the world’s major finan- cial institutions that deal in privately negotiated derivatives, as well as their clients who rely
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