Professional Documents
Culture Documents
swaps
Company A Company B
LIBOR +1% = 5.33%+1 * $ 20
M = $1,200,000 = $ 1,266,000
Company C, a U.S. firm, and Company D, a European firm, enter into a five-
year currency swap for $50 million. Assume the exchange rate at the time is
$1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms will
exchange principals. So, Company C pays $50 million, and Company D pays
Euros 40 million. This satisfies each company's need for funds denominated in
another currency (which is the reason for the swap).
CASH FLOWS FOR A PLAIN VANILLA
CURRENCY SWAP, STEP 2
Interest: € 40 M* 3.50%
Company C Company D
(US – (European-
based) base)
Interest: $50 M*8.25%
The agreed-upon dollar-denominated interest rate is 8.25%, and the
euro-denominated interest rate is 3.5%. Thus, each year, Company C
pays € 40,000,000 * 3.50% = €1,400,000 to Company D. Company D
will pay Company C $50,000,000 * 8.25% = $4,125,000. As with
interest rate swaps, the parties will actually net the payments against
each other at the then-prevailing exchange rate. If, at the one-year
mark, the exchange rate is $1.40 per euro, then Company D's
payment equals $1,960,000, and Company C would pay the
CASH FLOWS FOR A PLAIN VANILLA
CURRENCY SWAP, STEP 3
Principal: € 40 M
Company C Company D
(US – (European-
based) base)
Principal : $50 M
The agreed-upon dollar-denominated interest rate is 8.25%, and the
euro-denominated interest rate is 3.5%. Thus, each year, Company C
pays € 40,000,000 * 3.50% = €1,400,000 to Company D. Company D
will pay Company C $50,000,000 * 8.25% = $4,125,000. As with
interest rate swaps, the parties will actually net the payments against
each other at the then-prevailing exchange rate. If, at the one-year
mark, the exchange rate is $1.40 per euro, then Company D's
payment equals $1,960,000, and Company C would pay the
Size of the Swap Market -
2008
• The notional amounts outstanding of over-the-
counter (OTC) derivatives continued to expand
in the first half of 2008.
• Notional amounts of all types of OTC contracts
stood at $683.7 trillion at the end of June, 15%
higher than six months before.
• The average growth rate for outstanding CDS
contracts over the last three years has been
45%. In contrast to CDS markets, markets for
interest rate derivatives and FX derivatives both
recorded significant growth.
Source: http://www.bis.org/publ/otc_hy0811.htm
Size of the Swap Market -
2008
• A Credit Default Swap
(CDS) is like an
insurance contract.
• In principle, it lets
someone who wants to
own a company's bonds
but doesn't want to risk
the company defaulting
buy insurance from
someone else, who is
willing to pay the buyer
of CDS protection the
face value of the bond if
a default happens.
• http://db.riskwaters.com/public/showPage.html?page=113
Swap and forex operations
in India
• The Indian foreign
exchange market has
grown significantly in the
last several years.
• The daily average
turnover has gone up from
about USD 5 billion per
day in 1998 to more than
USD 50 billion per day in
2008.
• There is also evidence of
growing merchant
turnover reflecting the
huge increase in external
transactions.
• The Total Turnover forex
operation between April
Currencies of the Swap
Market
• The most
popular
currencies are:
– U.S. dollar
– Japanese yen
– Euro
– Swiss franc
– British pound
sterling
The Swap Bank
The Swap Bank
• A swap bank is a • The swap bank
general term to can serve as
describe a either a broker or
financial a dealer.
institution that – As a broker, the
facilitates swaps swap bank
between matches
counterparties. counterparties but
does not assume
• They are the any of the risks of
market-makers in the swap.
most cases – As a dealer, the
swap bank stands
ready to accept
either side of a
An Example of an Interest
Rate Swap
“Plain Vanilla” Interest Rate Swap.
• Bank A is a AAA-rated international
bank located in the U.K. and wishes
to raise $10,000,000 to finance
floating-rate Eurodollar loans.
– Bank A is considering issuing 5-year
fixed-rate Eurodollar bonds at 10
percent.
– It would make more sense to for the
bank to issue floating-rate notes at
LIBOR to finance floating-rate
An Example of an Interest
Rate Swap
• Firm B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a
five-year economic life.
– Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
– Alternatively, firm B can raise the money by
issuing 5-year floating-rate notes at LIBOR + ½
percent.
– Firm B would prefer to borrow at a fixed rate.
An Example of an Interest
Rate Swap
The borrowing opportunities of
the two firms are:
An Example of an Interest
Rate Swap 103/8%
Swap
Bank A
Bank
LIBOR -1/8%
The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per
year on $10 million for 5 years and we will pay you 10 3/8% on $10
million for 5 years
An Example of an Interest
Rate Swap 103/8%
10.0%
Swap
Bank A
Bank
LIBOR -1/8%
½% of $10,000,000 = $50,000. That is quite a cost savings per year for 5 years.
Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net
borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better
than they can borrow floating without a swap.
An Example of an Interest
Rate Swap 10½%
Swap Company
Bank B
LIBOR - ¼%
The swap bank makes this offer to company B: You pay us 10½% per year
on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on
$10 million for 5 years.
Here’s what’s in it for B:
10½%
+½%
Swap Company
Bank B
LIBOR - ¼%
They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½
+ (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow
floating.
½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years.
An Example of an Interest
Rate Swap
103/8% 10½%
Swap Company
Bank A Bank B
LIBOR -1/8% LIBOR - ¼%
Swap Company
Bank A Bank B
LIBOR -1/8% LIBOR - ¼%
A saves ½% B saves ½%
An Example of a
Currency Swap
• Suppose a U.S. MNC wants to
finance a £10,000,000 expansion of a
British plant.
• They could borrow dollars in the
U.S. where they are well known and
exchange for dollars for pounds.
– This will give them exchange rate risk:
financing a sterling project with
dollars.
• They could borrow pounds in the
international bond market, but pay
a premium since they are not as
An Example of a
Currency Swap
• If they can find a British MNC
with a mirror-image financing
need they may both benefit from
a swap.
• If the spot exchange rate is
S0($/£) = $1.60/£, the U.S. firm needs to
find a British firm wanting to finance
dollar borrowing in the amount of
Example: a Currency
Swap
Consider two firms A and B: firm A is a U.S.–based
multinational and firm B is a U.K.–based
multinational.
Both firms wish to finance a project in each other’s
country of the same size. Their borrowing
opportunities are given in the table below.
A Currency Swap
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
A Currency Swap
A’s net position is to borrow at £11%
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
A saves £.6%
11.6
%
A Currency Swap
B’s net position is to borrow at $9.4%
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
B saves $.6%
10.0
%
A Currency Swap
The swap bank makes money too:
$8 $9.4
$8 £12
Firm Swap Firm
A Bank B
£11 £12
1.4% of $16 million financed with 1% of £10 million per year for 5 years
At S0($/£) = $1.60/£, that is a gain of $124,000 per year for 5 years.
The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).
The QSD
• The Quality Spread Differential
represents the potential gains from the
swap that can be shared between the
counterparties and the swap bank.
• There is no reason to presume that the
gains will be shared equally.
• In the above example, company B is
less credit-worthy than bank A, so they
probably would have gotten less of the
QSD, in order to compensate the swap
Comparative Advantage
as the Basis for Swaps
A is the more credit-worthy of the
A pays
two 2% less to borrow in dollars than B
firms.
A pays .4% less to borrow in pounds than B: