Interest Rate and Currency Swaps
Triumvirate of Risks.
Define and explain the three main financial risks facing a multinational
The three financial price risks facing all MNEs are exchange rate risk, interest rate risk, and
commodity price risk. The first, exchange rate risk, was the subject of prior chapters and focused
on transaction exposure, operating exposure, and accounting exposure. The second financial price
risk, interest rate risk, can be subdivided into debt service (MNE liabilities) and interest-bearing
securities (MNE assets). The third risk, commodity price risk, is the risk and exposure of the firm
to key commodity input price changes such as oil, metals, agricultural inputs, etc.
What is an interest “reference rate” and how is it used to set rates for individual
Whether it is on the left or right side, the
of interest calculation merits special
—for example, U.S. dollar LIBOR—is the rate of interest used in a
standardized quotation, loan agreement, or financial derivative valuation. LIBOR, the London
Interbank Offered Rate, is by far the most widely used and quoted. It is officially defined by the
British Bankers Association (BBA). U.S. dollar LIBOR is the mean of 16 multinational banks’
interbank offered rates as sampled by the BBA at approximately 11
. London time in London.
Similarly, the BBA calculates the Japanese yen LIBOR, euro LIBOR, and other currency LIBOR
rates at the same time in London from samples of banks.
The interbank interest rate market is not, however, confined to London. Most major domestic
financial centers construct their own interbank offered rates for local loan agreement purposes.
These rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered
Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Interbank Offered Rate),
to name but a few.
Risk and Return.
Some corporate treasury departments are organized as service centers
(cost centers), while others are set up as profit centers. What is the difference and what are
the implications for the firm?
Before they can manage interest rate risk, treasurers and financial managers of all types must
resolve a basic management dilemma: the balance between risk and return. Treasury has
traditionally been considered a service center (cost center) and is therefore not expected to take
positions that incur risk in the expectation of profit. Treasury activities are rarely managed or
evaluated as profit centers. Treasury management practices are, therefore, predominantly
conservative, but opportunities to reduce costs or actually earn profits are not to be ignored.
History, however, is littered with examples in which financial managers have strayed from their