swaps - FX and Interest Rate Swaps FBE 436 Professor Aris...

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Unformatted text preview: FX and Interest Rate Swaps FBE 436 Professor Aris Protopapadakis 1 Key Concepts & Skills What are swaps How do swaps work? The legal features of swaps Alternatives to swaps 4 What Are Swaps? They are derivatives • It means that they can be replicated from primary securities There are two main types: Interest rate swaps FX swaps 5 1 Interest Rate Swaps Company A borrows long-term Company B borrows short-term They “swap” their obligations A pays B’s interest payments B pays A’s interest payments 6 FX Swaps Company A borrows in ¥ Company B borrows in € They “swap” their obligations A pays B’s interest payments in € B pays A’s interest payments in ¥ 7 Why Study Swaps? Swaps have become very common financial instruments Swaps add flexibility to financing and hedging operations Swaps fill the needs for more permanent, and longer term hedging compared to forwards or futures 8 2 Why Study Swaps? Swaps offer very easy ways to hedge medium and even long-term FX and Term structure exposure Less expensive, more flexible, and cheaper than issuing foreign currency debt directly 9 An Example of FX Swap The example that follows is not the currently predominant way of doing swaps It is based on the notion that there have to be two identifiable parties simultaneously interested in a swap (barter) This barter arrangement is unnecessary now, because there is a very liquid market for swaps But the example presents the whole picture of the swap market It is what has to happen in the aggregate 10 An Example of a FX Swap Monsanto is based in the US Wants to hedge some of its € cash flow with a Euro loan ABB is based in Europe Wants to hedge some of its $ cash flow with a $ loan Both firms have outstanding loans in their own currencies 11 3 Monsanto & ABB Here is the initial and desired situations for both companies: 12 Monsanto & ABB (cnt.) Initial Situation Company Currency Receipts Payments Monsanto € No Yes $ Yes Yes ABB € Yes Yes $ No Yes Desired Situation Company Currency Receipts Payments Monsanto € Yes Yes $ Yes Yes ABB € Yes Yes $ Yes Yes 13 Monsanto & ABB (cnt.) Monsanto & ABB can agree to “swap” some of their debt This would help both hedge their exposures The following loans are available to them: 14 4 Monsanto & ABB (cnt.) Available Borrowing Rates Premium Currency Rate Over T-Notes (bp) 7.00% n.a. Euro T-Note € 7.75% n.a. $ US T-Note 9.60% 260 Monsanto € 9.75% 200 $ 8.25% 125 ABB € 9.50% 175 $ Difference Between Companies n.a. n.a. 135 25 -135 -25 15 Monsanto & ABB (cnt.) ABB can borrow at lower rates in both currencies But, its comparative advantage is borrowing in the € This implies possible gains from trade 16 Monsanto & ABB (cnt.) Strategy #1: Monsanto borrows €s @ 9.60% (ABB = 8.25) ABB borrows $s @ 9.50% (M = 9.75%) Strategy #2: Monsanto borrows $s @ 9.75% (ABB = 9.50) ABB borrows € s @ 8.25% (M = 9.60%) and they SWAP 17 5 Monsanto & ABB (cnt.) Winning Strategy: Monsanto borrows $s @ 9.75% (ABB = 9.50) ABB borrows € s @ 8.25% (M = 9.60%) and they SWAP 18 Monsanto & ABB (cnt.) Very roughly, for the two companies taken together They save 135 bp by ABB borrowing €s They lose 25 bp by Monsanto borrowing $s They have to compensate the broker a little No brainer! 19 Monsanto & ABB (cnt.) The two companies need to be brought together Financial intermediary There are fairly tedious calculations that actually “price” this swap This means you can figure out exactly who pays what to whom! Each of the three parties need a financial incentive in order to agree 20 6 Monsanto & ABB (cnt.) Final Disposition Premium Currency Rate Over T-Notes (bp) 7.00% n.a. Euro T-Note € 7.75% n.a. $ US T-Note Monsanto € 9.75% 200 $ 8.25% 125 ABB € $ Difference Between Companies n.a. n.a. 21 Monsanto & ABB (concl.) Obviously ABB won’t pay a higher rate for a $ loan that what they can pay on their own (9.50% vs. 9.75%) Nor is Monsanto going to be able to take advantage of the much lower rate that ABB can get on a € loan on its own (8.25% vs. 9.60%) Up front payments make everyone happy! are exchanged to 22 Swaps Are Commodities Standard swaps are commodities They are readily quoted Swap dealers give an “indication” A list of bid/ask spreads for swaps in various currencies and maturities Swaps usually involve semi-annual payments (coupon) and a bullet payment at the end 23 7 Swaps Are Commodities (cnt.) FX swaps generally involve up front cash payments or receipts, including payment to the broker or dealer The dealers stay even –no exposure Swaps started in 1982 to help change the maturity and/or the currency of one’s liabilities At low cost and quickly ($7 Trillion market) 24 Institutional Features Counterparties The legal entities that issue the debt and agree to the swap Intermediary The broker that mediates or puts together the transaction Notional Principal Amount on which interest payments are calculated 25 Institutional Features (cnt.) Each company is responsible for its original loan There is “right of offset” In some countries this is prohibited The intermediary does not bear responsibility for either side’s performance A company can “buy out” a swap by paying the other party the difference in the current PV of the swap arrangement The other party is “made whole” 26 8 Institutional Features (concl.) In the US, Short rates are quoted on a 360-day basis Long rates are quoted on a 365-day basis To evaluate swaps, all rates must be converted to a consistent basis 27 Alternatives to Swaps If swaps are derivatives, there must be alternative ways to achieve the same financial result Examining these will deepen our understanding of swaps 28 Alternatives to Swaps (cnt.) Monsanto can secure a € loan Long-term floating (bank) Long-term fixed (private or public placement) Should retire some $ loans Costs associated with issuing bonds Flotation costs Heightened public scrutiny 29 9 Alternatives to Swaps (cnt.) Monsanto can make a series of long-term forward contracts with banks To deliver € equal to the interest payments it wants to make Long-term forward contracts have a thin market and therefore high premia 30 Alternatives to Swaps (cnt.) Monsanto can make short-term forward contracts and keep rolling them over to deliver € equal to the interest payments it wants to make Roll-over hedging is good but not perfect A lot of currency changes hands frequently 31 Alternatives to Swaps (cnt.) Monsanto and ABB can enter into parallel loans Monsanto borrows € from ABB ABB borrows $ from Monsanto • All at market risk-premia No right to offset without an explicit agreement Usually parent loans to the other’s subsidiary • Legal issues, costs, delays • Essentially a barter arrangement 32 10 Alternatives to Swaps (cnt.) Back-to-back loans are better than parallel loans, because the transaction involves a single document Some countries prohibit right-of-offset for loans Any kind of outright loan shows up in the books; swaps don’t 33 Alternatives to Swaps (concl.) Use Put options Not directly comparable –one-sided risk! Rollover issues Market depth issues FX swaps are frequently both a currency and a maturity exchange 34 Interest Rate Swaps An interest rate swap: Alpha company has long-term (fixed rate) debt but • Would like short-term (floating rate) debt Zeta company has short-term debt but • Would like long-term debt Same institutional arrangements 35 11 Institutional Features Interest Rate Swaps only To “go long” on a swap means To take the fixed rate (long maturity) side of the swap The floating side of a swap is typically LIBOR + The fixed-rate side of a swap is typically Treasury Notes + 36 Alpha & Zeta Before the Swap Company Maturity Receipts Payments Alpha Floating 9.00% -Fixed -10.00% Zeta Floating -9.10% Fixed 11.00% -LIBOR 8.00% 37 Alpha & SuperBank Alpha Zeta Floating Fixed Floating Fixed 9.00% 10.00% 8.80% 10.00% 9.10% 11.00% SuperBank's Position Company Maturity Receipts Payments SuperBank Floating 8.80% 10.00% Fixed 38 12 Zeta & SuperBank Alpha Zeta Floating 9.00% Fixed Floating 9.10% Fixed 11.00% 10.00% 9.10% 10.50% SuperBank's Position Company Maturity Receipts Payments SuperBank Floating 9.10% Fixed 10.50% 39 Alpha, Zeta & SuperBank Combo Alpha Zeta Floating Fixed Floating Fixed 9.00% 10.00% 9.10% 11.00% 8.80% 10.00% 9.10% 10.50% SuperBank's Position Company Maturity Receipts Payments 9.10% SuperBank Floating 8.80% 10.50% 10.00% Fixed 40 End Result Alpha Earns 20 bps on the floating side Is even on the fixed side Zeta Is even on the floating side, Earns 50 bps on the fixed side SuperBank Pays 30 bps on the floating side Earns 50 bps on the fixed side 41 13 Takeaways A swap is an exchange of one kind of liability for another A currency swap is an exchange of debt in one currency for debt in another currency An interest rate swap is an exchange of short-term for long-term debt, in the same currency. Swaps are “commodities” and quotes for several maturities and currencies are readily available 42 The End 43 14 ...
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