Interest rate and currency swap market

Presented by: Vikas Singh 11/PMB/096

Chapter Outline

Types Typesof ofSwaps Swaps Sizeof ofthe the Swap Market Size Swap Market TheSwap Swap Bank The Bank SwapMarket Market Quotations Swap Quotations InterestRate Rate Swaps Interest Swaps CurrencySwaps Swaps Currency Variationsof ofBasic Basic Interest Rate Currency Swaps Variations Interest Rate andand Currency Swaps Risksof ofInterest Interest Rate and Currency Swaps Risks Rate and Currency Swaps Is the theSwap Swap Market Efficient? Is Market Efficient?

Definitions

In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps: Single currency interest rate swap Plain vanilla fixed-for-floating swaps are often just called interest rate swaps. Cross-Currency interest rate swap This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

Size of the Swap Market

In 2007 the notational principal of: Interest rate swaps was $271.9 trillion USD. Currency swaps was $12 trillion USD The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling

The Swap Bank

A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer.
As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

Swap Market Quotations

Swap banks will tailor the terms of interest rate and currency swaps to customers needs They also make a market in plain vanilla swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

The convention is to quote against U.S. dollar LIBOR.

Interest Rate Swap Quotations

Euro-
Bid 1 year 2 year 2.34 2.62 Ask 2.37 2.65

Sterling
Bid 5.21 5.14 Ask 5.22 5.18

Swiss franc
Bid 0.92 1.23 Ask 0.98 1.31

U.S. $
Bid 3.54 3.90 Ask 3.57 3.94

3 year
4 year 5 year 6 year 7 year 8 year 9 year 10 year

2.86
3.06 3.23 3.38 3.52 3.63 3.74 3.82

2.89 3.82 5.13 3.855.17 means 1.50 the

1.58bank 4.11 4.13 swap will pay 3.09 fixed-rate 5.12 5.17 1.73 1.81 4.25 4.28 euro payments at 3.82% 3.26 against 5.11 receiving 5.16 1.93 2.01 4.37 4.39 euro LIBOR or it will 3.41 receive 5.11 fixed-rate 5.16 2.10 2.18 4.46 euro payments at 4.50 3.55 3.85% 5.10 against 5.15 receiving 2.25 2.33 4.55 4.58 euro LIBOR
3.66 3.77 3.85 5.10 5.09 5.08 5.15 5.14 5.13 2.37 4.48 2.56 2.45 2.56 2.64 4.62 4.70 4.75 4.66 4.72 4.79

Swap Quotations
3.823.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR 3.85% Firm B $LIBOR

Swap Bank

3.82% $LIBOR

Firm A

While most swaps are quoted against flat dollar LIBOR, off-market swaps are available where one party pays LIBOR plus or minus some number.

Example of an Interest Rate Swap

Fixed Floating Consider firms A and B; each firm wants to A 5% LIBOR borrow $40 million for B 5.50% LIBOR + .20% 3 years. Firm A wants finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate.

A has good credit and can borrow at LIBOR Firm B wants finance an interest-rate-insensitive asset and therefore wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow at 5.5% The swap bank quotes 5.15.2 against dollar LIBOR for a 3-year swap.

Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank

If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.15.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR 0.10%

Bank X

As all-in-cost: = 5.0% + LIBOR 5.10% = LIBOR 0.10%

Example of an Interest Rate Swap

Swap Bank
5.20%

Firm B LIBOR

If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.15.2 they can convert their floating rate debt into a fixed rate debt at 5.40% Bs all-in-cost: = LIBOR + LIBOR + 0.20% + 5.20% = 5.40%

Bank Y

Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank
5.20%

Firm B LIBOR

The Swap Bank makes 10 basis points on the deal: The Swap Banks all-in-cost:

= LIBOR + LIBOR 5.20% + 5.10% = 0.10%

Example of an Interest Rate Swap

Firm 5.10% A LIBOR Swap Bank
5.20%

Firm B LIBOR

The notional size is $40 million. The tenor is for 3 years.

Bank X

A earns $40,000 per year on the swap. B earns $40,000 per year on the swap. Swap Bank earns $40,000 per year.

Bank Y

What about the Principal?

In our plain vanilla interest-only interest rate swap just given, we did not mention swapping the Notational Principal.
It could be the case that firm A exchanged principal with their lender (Bank X) and firm B exchanged principal with their outside lender, Bank Y.

Example of an Currency Swap

$ Firm A is a U.S. MNC and wants to borrow 40 million for 3 years. A $7% 6% Firm B is a French MNC and B $8% 5% wants to borrow $60 million for 3 years Firm A wants finance euro denominated asset in Italy and therefore wants to borrow euro.

A can borrow euro at 6% Firm B wants finance a dollar denominated asset and therefore wants to borrow dollars. B can borrow dollars at 8% The current exchange rate is $1.50 = 1.00

Example of a Currency Swap

Suppose

that the Swap Bank publishes these

quotes. The convention is to quote against U.S. dollar U.S. $ LIBOR. Euro- Bid Ask Bid Ask

3 year 5.00 5.20

7.00

7.20

Firm A wants finance eurodenominated asset in Italy and wants to borrow euro. A can borrow euro at 6% or they can borrow euro at 5.2% by using a currency swap.

$ A $7% B $8%

6% 5%

Example of a Currency Swap

(The convention is to quote against U.S. dollar LIBOR.)

Euro-

U.S. $

$
A $7%

6%

Bid Ask 5.00 5.20

Bid 7.00 $7.0%

$60m

Ask 7.20

B $8%

5%

LIBOR

Bank X

Firm A
40m
$60m

$7.0% 5.2% LIBOR

Swap Bank

Suppose that Firm A borrows $60m at $7%; trades for at spot.

Firm A then enters in to 2 fixed for floating

FOREX Market

Example of a Currency Swap

(The convention is to quote against U.S. dollar LIBOR.)

Euro- Bid Ask

U.S. $ Bid Ask 7.00 LIBOR 7.20

$
A $7%

6%

5.00 5.20

B $8%

5%

Swap Bank
LIBOR

$7.2% 5.0%
$60m 40m

Firm B

40m 5%

Bank Y

Suppose that Firm B borrows 40m at 5%, trades for $.

FOREX Market Firm B then enters in to 2

fixed for floating swaps.

Example of a Currency Swap

Swap Bank earns 40 bp per year (20bp in $ and 20bp in ).

Firm A

$7.0% 5.2%

Swap Bank

$7.2%

Firm B 5.0%

The notional size is $60m. The tenor is for 3 years.

Bank X

Firm A earns 80 BP per year on the swap and hedges exchange rate risk.
Firm B earns 80 bp per year on the swap and hedges exchange rate risk.

Bank Y

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.

$
A B QSD $7% $8% 1%

The QSD is calculated as 6% the difference between the differences. 5%

1% = 2%

Comparative Advantage as the Basis for Swaps

A has a comparative advantage in borrowing in dollars. B has a comparative advantage in borrowing in euro. $ A $7% 6% B $8% 5%

Variations of Basic Currency and Interest Rate Swaps

Currency Swaps fixed for fixed fixed for floating floating for floating amortizing Interest Rate Swaps zero-for floating floating for floating

Risks of Interest Rate and Currency Swaps

Interest Rate Risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Risks of Interest Rate and Currency Swaps (continued)

Credit Risk This is the major risk faced by a swap dealer the risk that a counter party will default on its end of the swap. Mismatch Risk Its hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. Sovereign Risk The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

Swap Market Efficiency

Swaps offer market completeness and that has accounted for their existence and growth. Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

Concluding Remarks

The growth of the swap market has been astounding. Swaps are off-the-books transactions.
Swaps have become an important source of revenue and risk for banks

Sample Currency Swap Problem

A is an Italian firm A can borrow in euro at 5% fixed A prefers to borrow in dollars but faces $8% cost B is an American firm B has already borrowed in dollars at $8% 5 years ago they issued a 15-year bond B now prefers to borrow in euro but faces 6% cost Both firms want a 10-year maturity Devise a feasible swap that eliminates exchange rate risk for A and B

Thank You