INTEREST RATE SWAPS

Somewhat complex, innovative financing arrangement for corporations that can reduce borrowing costs and increase control over interest rate risk and foreign exchange exposure.  Relatively new market, due to financial deregulation, integration of world financial markets, and currency and interest rate volatility.  Market has grown significantly, see Exhibit 10.1, p. 228.  Total amount of outstanding interest rate swaps in 2001 was almost $59T, and almost $4T in currency swaps, fastest growth was for Interest Rate Swaps.  5 main currencies: $, €, ¥, BP and SF.   

Interest Rate Swap financing involves two parties (MNCs) who agree to exchange CFs, results in benefits for both parties.  Single-currency interest rate swap is usually just called an Interest Rate Swap.  Cross-currency interest rate swap is called a Currency Swap.

Basic (plain vanilla) Interest Rate Swap involves exchanging (swapping) interest payments on Floating-rate debt for interest payments on Fixed-rate debt, with both payments in the same currency.  Reason: One party actually wants fixed rate debt, but can get a better deal on floating rate; the other party wants floating rate debt, but can get a better deal on fixed rate.  Both parties can gain by swapping loan payments (CFs), usually through a bank as a financial intermediary (FI), which charges a fee to broker the transaction.

Currency Swap - One party swaps the interest payments of debt (bonds) denominated in one currency (USD) for the interest payment of debt (bonds) denominated in another currency (SF or BP), usually on a "fixed-for-fixed rate" basis.  Currency swap is used for cost savings on debt, or for hedging long term currency risk.

SWAP BANK - Financial Institution (FI) in the swap business, either as dealer or broker, usually large commercial and investment banks.  Broker bank: Arranges and brokers the deal, but does not assume any of the risk, just charges a commission/fee for structuring and servicing the swap.  Dealer bank: Bank that is willing to take a position on one side of the swap or the other, and therefore assume some risk (interest rate or currency).  Dealer would not only receive a commission for arranging and servicing the swap, but would take a position in the swap, at least until it sold its position later.

Example: Banks trading currency forward contracts.  If they always match shorts and longs, there is no risk, acting as brokers.  For every party who want to buy BP forward from the bank, there is a party selling BP forward to the bank.  If the bank has a client who wants to sell £10m forward (short position) in 6 months, and accepts the contract without a forward BP buyer (long), it is exposed to currency risk by taking the long position itself.  As a trader-broker, the bank can do more business than just a broker, by assuming risk exposure.   

EXAMPLE 10.1 OF INTEREST RATE SWAP, pages 229-231.

Bank A is AAA-rated bank in U.K., and needs $10m cash inflow to finance floating-rate, 5-year Eurodollar term loans to its commercial clients.  To minimize (eliminate) interest rate risk, bank would prefer to match floating-rate debt (CDs or notes) with its expected floating-rate assets (Eurodollar loans).  It has two sources of debt available:

a) 5-YR FIXED-RATE BONDS @ 10% or
b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR

With floating rate loans and fixed rate debt, there is interest rate risk. Worried about? 

Therefore, bank prefers floating-rate debt, to match the floating rate loan (asset). 

Company B is a BBB rated MNC in U.S., needs $10m for 5 years to finance a capital expenditure (new project, investment in property/plant, replace worn out equipment, etc.).  It has two sources of debt available:

a) 5-YR FIXED-RATE BONDS @ 11.75%
b) 5-YR FLOATING-RATE NOTES (FRNs) @ LIBOR + .50%

With FRNs there is interest rate risk if interest rates _____.  Therefore, MNC prefers fixed-rate debt to guarantee a fixed, stable interest expense.  

Swap Bank can broker an interest rate swap deal (for a fee) with Bank A and Company B that will benefit both counterparties.  When structured properly all three parties will benefit (Bank A, Company B, and the swap bank).  Similar to the gains from trade in Ch. 1.  Here is how (Exhibit 10.2):

                             "Risky" BBB      "Safe" AAA

                       Company B         Bank A          Difference                     Risk Premium      
Fixed-Rate          11.75%              10%            (11.75 - 10%)                    1.75%

Floating-Rate     LIBOR +.5%      LIBOR        (LIBOR + .5%) - LIBOR      .50%
                                                                                                      QSD 1.25%

The key to an interest-rate swap is the QSD (Quality Spread Differential), the difference or spread between fixed interest rates (Risky - Safe), and variable interest rate (Risky - Safe).  Co. B would have to pay 1.75% more than Bank A for fixed rate debt, but only .5% more for variable rate.  The QSD is 1.25% , reflecting the difference, or additional default risk premium on fixed rate debt.  The yield curve (fixed rate) for risky debt is much steeper than for safe debt, since lenders will: 1) Not have an opportunity to adjust (raise) the rate, and 2) Not have the opportunity to cancel the debt if the company gets in trouble, and 3) Not be able to change the terms of the loan.  All of these would be possible under floating-rate agreements, and lenders therefore have to "lock-in" a high default risk premium for fixed-rate debt at the beginning of the loan. 

When a QSD exists, it represents the potential gains from trade if both parties get together, through the swap bank.  Here is an example of how the 1.25% QSD can be split up as follows: .5% for each party (bank and MNC) in the form of interest rate savings and .25% profit for the bank to arrange the deal.  For $10m, each party (Bank A and Co. B) can save $50,000/year for 5 years, and the bank will make $25,000/yr for 5 years (total of $625,000 to split). 

Without the swap, Bank A will pay variable-rate @ LIBOR, and Co. B will pay fixed-rate @ 11.75%.  With the swap, each party will save .5%, as follows:  Bank A will pay a all-in-cost (interest expense, transactions cost, service charges) interest expense of LIBOR - .5% (saving .50%) and Co. B will pay all-in-cost interest expense of 11.25% (saving .50%).  Here is how:

Instead of actually issuing the type of debt they really want, each party issues the opposite of what they want, and then they swap CFs.  Instead of variable debt at LIBOR, Bank A issues fixed-rate bonds at 10%.  Instead of issuing fixed rate at 11.75%, Co. B issues variable-rate debt at LIBOR + .5%.  The parties issue the debt that they don't want, and make interest payments directly to the bondholders for 5 years.  The swap bank then arranges the following CF payments:

1. Co. B pays 10.50% fixed-rate interest (on $10m) to the Swap Bank, and the bank passes on 10.375% interest payment to Bank A in U.K.  (Swap bank makes the difference = 10.50% - 10.375% = .125%).

2. Bank A pays LIBOR - .125% on $10m to the Swap Bank and they pass on LIBOR - .25% to Company B.

As a result, here is the net position of each party:

Bank A
Pays -10% Fixed-rate interest (on $10m) to bondholders
Receives +10.375% fixed rate interest from Swap Bank (Net on fixed rate debt = +.375%)
Pays variable -(LIBOR -.125%) rate to Swap Bank (Reduced by +.375% on fixed rate debt)
NET INTEREST = LIBOR - .50% variable rate (w/swap), vs. LIBOR (w/o swap)

Company B
Pays -10.50% Fixed-rate to Swap Bank
Pays Variable-rate LIBOR + .5% to bondholders
Receives LIBOR - .25% from Swap Bank (Net on variable-rate debt = -.75%)
NET INTEREST = 11.25% Fixed Rate (w/swap), vs. 11.75% (w/o swap)

Swap Bank
Receives 10.50% fixed-rate from Co. B
Pays 10.375% to Bank A (Net of +.125% on fixed-rate debt)
Receives LIBOR -.125% from Bank A
Pays LIBOR -.25% to Co. B (Net of +.125% on variable-rate debt)
NET INCOME = .25% (on $10m)

Net result: Bank A borrows at LIBOR - .5% instead of LIBOR, gets a variable-rate, and saves 0.50%. 

Co. B borrows at 11.25% instead of 11.75%, gets a fixed rate, and saves .50%.  Swap Bank makes .25% to arrange the deal.     

Note: All interest payments/CFs are in USD.  Actually, only the net difference in dollar CFs actually needs to be exchanged, NOT the gross amount.  Example: Suppose that when the first payment is due LIBOR is 8%.

 CFs for Co. B:
Pay $1.050m to Swap Bank (10.50% x $10m)
Receive $775,000 from Swap Bank (7.75% x $10m), (LIBOR - .25% = 7.75%)
Net PMT to SWAP BANK = $275,000

Pay $850,000 to bondholders (LIBOR + .5%) x $10m.

Total interest expense = $275k + $850k = $1.125m (or 11.25% of $10m), vs. $1.175m @ 11.75%, or a savings of $50,000 per year.   

 CFs for Bank A:
Receive $1.0375m from Swap Bank (10.375% of $10m)
Pay $787,500 to Swap Bank (7.875% of $10m)
Net RECEIPT from SWAP BANK = $250,00

Pay $1m to bondholders ($10m x 10%)

Total Interest Expense = $1m - $250,000 = $750,000 (7.5% of $10m, @LIBOR -.50%), vs. $800,000 @ LIBOR, or a savings of $50,000. 

Swap Bank Receives $275,000 from Co. B, and pays $250,000 to Bank A, profit of $25,000/year.

Regardless of what happens to LIBOR, the Swap Bank will always receive $25,000 profit/year.

Problem Set question: Show the CFs above when LIBOR = 6% and verify that the bank will make $25,000.  Repeat for LIBOR = 10%.
 

CURRENCY SWAPS

Another risk management tool for currency risk, especially long term.  The original currency swaps were actually developed as a way to circumvent foreign exchange controls in U.K.  British govt. imposed high taxes on foreign exchange transactions to encourage domestic investment and discourage capital outflows and foreign investment.  With a Parallel Loan, the taxes could be avoided.

"The reason that taxes/price controls/interest rate controls/regulations/foreign exchange controls are DISTORTIONARY, is that they can be avoided."

Example of Parallel Loan:  Four parties are involved.  1) U.K. parent company, and 2) Subsidiary company in Canada.  3) Canadian parent company, and 4) Subsidiary in U.K.  Assume that typical borrowing costs are 10% in U.K. and 11% in Canada.  U.K. parent company would like to borrow money to finance expansion of its subsidiary in Canada.  If it borrows in U.K. (pounds) and converts to C$ it will be severely taxed.  Also, the Canadian subsidiary is not well known in Canada, so it would have to pay a 2% risk premium over the normal rate (11 + 2 = 13%), and 13% is considered too high.

Assume that the Canadian parent company is in the same situation, it has a subsidiary in U.K. that would have to pay a 3% risk premium because it is not well known in UK.  Borrowing costs in UK (pounds) for the Canadian subsidiary would be 10% + 3%  = 13%, which is considered to be excessive.

Parallel Loan: U.K. parent company borrows in U.K. at 10% in £s, and re-lends the money to the Canadian subsidiary in U.K.  Canadian parent company borrows C$ at 11% and re-lends the money to the U.K. subsidiary in Canada.  Since no currency leaves the U.K., there is no tax.  See Exhibit 10.4 on page 232 for a diagram of CFs.

During the loan, the U.K. subsidiary in Canada earns C$ to pay the interest and principal.  The Canadian subsidiary in U.K. earns pounds to pay back the loan.  Result: U.K. subsidiary in Canada pays 11% instead of 13% (savings of 2%) and the Canadian subsidiary in U.K. pays 10% instead of 13% (savings of 3%).  
 

BACK-TO-BACK LOAN

Similar to a Parallel loan, but only involves 2 parties, not 4. See Exhibit 10.5 on page 259.  Assume that the same conditions hold, int. = 10% in U.K. and int. = 11% in Canada.  British parent firm borrows in U.K. at 10% and re-lends to Canadian parent firm.  Canadian parent firm borrows in Canada at 11% and re-lends those funds to U.K. firm.  U.K. firm makes payments annually to Canadian firm in C$ and Canadian firm makes payments to UK firm in pounds.

The British (Canadian) parent firm could re-lend the C$s (pounds) to its subsidiary in Canada (UK), and effectively accomplish the same goal as the parallel loan scenario.  But in this case the two parent companies deal directly with each other, so there are only two parties to the agreement, vs. four parties in the last example.

Potential problems with parallel and back-to-back loans:
1. Time-consuming and expensive to set up.  You have to search for and find two MNCs in almost the exact opposite position at the same time.
2. Potential for default.  What if the Canadian subsidiary of the U.K. firm defaults on the parallel loan?  The parent is still liable.  To minimize these problems a legal document called a "rights of set-off" is usually in effect to address the potential problems of default.
 

BASIC CURRENCY SWAP

Natural extension of parallel and back-to-back loans.

Currency Swap Example 10.5 on p. 234.  U.S. MNC like GM has a subsidiary in Germany, and there is an investment opportunity for expansion in Germany that will require €40m and will have an economic life of 5 years.  Current spot rate is $0.90/€, so the firm could consider raising $36m in U.S. by issuing bonds at 8% (payable in dollars), and converting $36m to €40m to finance the expenditure.  Hopefully CFs (in Euros) would be generated from the project to make the interest payments in $.  Problem: Transaction Exposure (potential change in the financial position of the project due to currency changes over 5 years), because German earnings are in Euros, interest payments due in U.S. are in USD.  What is the MNC worried about???    

Alternative: Raise €40m in the Eurobond market by issuing 5-year Eurobonds, payable in Euros.  Eurobond rate is 6% for a well-known firm, but the German subsidiary of the U.S. MNC pays 7% because it is unknown (1% risk premium).

Assume there is a German MNC with a mirror-image financing need.  It has a U.S. subsidiary needing $36m for an expansion project in U.S. with a 5-year life.  German MNC could borrow Euros in Germany at 6% convert to dollars, but there is transaction exposure since dollar CFs would be generated in U.S. to make Euro interest payments in Germany.  Worried about what over 5 years???  Company could issue Eurodollar bonds in U.S., but would face a 9% (normal rate is 8%) interest rate because the German subsidiary is not well-known in U.S.

Swap Bank could arrange a Currency Swap to: 1) Eliminate the long-term currency risk for both MNCs (transaction exposure), and 2) Reduce interest expense for both companies.  Each company has a "comparative advantage" at raising money in its home country, so each MNC would issue debt domestically at a savings of 1% compared to the foreign MNC raising funds (U.S. company raises $36m in U.S. at 8%, vs. 9% for the German MNC; German company raises €40m in Germany at 6%, vs. 7% for the U.S. MNC).

The principal sums would be exchanged through a Swap Bank - U.S. company transfers $36m to the German subsidiary in U.S. and the German company transfers €40m to the U.S. subsidiary in Germany.  Every year the U.S. subsidiary in Germany would submit €2.4m (€40m @ 6% - instead of borrowing at 7%) to its parent company in U.S., which would transfer the money to the Swap Bank, which transfers funds to the German MNC to pay the Euro loan.  The German subsidiary in U.S. would submit $2.88m ($36m @ 8% - instead of 9% on its own) to the German MNC, which would transfer the money to the Swap Bank, and the bank would transfer to the U.S. MNC to pay for the dollar loan.  At maturity, principal payments would take place the same way.

Currency swap locks in three ex-rates: 

1. Principal sums are exchanged at the current ex-rate, $36m/€40m = $.90/€.   

2. The contractual (implicit) exchange rate for the annual payments would be $1.20/€, since the payments exchanged are: $2.88m / €2.40m = $1.20/€ (mistake in book), or €0.8333/$ 

3. The implied exchange at maturity for last interest payment and principal payment is $38.88m ($36m + $2.88m) / €42.40m (€40m + €2.40m) = $0.9170/€.  Therefore, the currency swap locks in a fixed exchange rate for YRS 1-4 and another ex-rate for YR 5, and there is no currency risk.

At first it might seem like the German company is not getting as good of a deal compared to the U.S. firm.  The German MNC borrows Euros at 6% but pays 8% in U.S. dollars.  However, IRP should hold, making the two interest rates equal after adjusting for the expected change in the value of the currencies.  Since int. rates are higher (lower) in the U.S. (Germany), the dollar (€) is expected to depreciate (appreciate), by 2% per year.  German MNC pays back the loan with a currency (USD) that is depreciating (USD is depreciating by 2% per year), Euro is appreciating by 2% per year.

German MNC borrows €s @ 6%, pays loan back in USDs at 8%, but since the dollar (Euro) is depreciating (appreciating) by 2%/year, the effective borrowing cost in Euros is 6%.

U.S. MNC borrows $s @ 8%, pays back Euros @ 6%, but since the USD (Euro) is getting weaker (stronger) by 2%, the effective borrowing cost in $ is 8%.
 

Point: In equilibrium (IRP), If the Euro is selling at a forward premium of +2%/year, the Borrowing Euros at 6% is exactly equivalent to borrowing dollars at 8%. 

SWAP MARKET QUOTATIONS

Swap Banks (dealers and brokers) will provide customized swaps, tailored to the needs of MNCs and other clients.  They also make a market in generic "plain vanilla" swaps for MNCs rated Aa or Aaa credit ratings, and provide current market quotations for these swaps.

Examples:
 

U.S. dollar generic fixed-for-floating interest rate swap indexed to dollar LIBOR, semiannual or annual payments, quoted as bid-ask spread.  Swap bank quotes fixed-rate bid-ask spread versus 6-mo dollar LIBOR. e.g., 8.50% - 8.60% quote.  Swap bank is willing to take either side of the int. rate swap transaction as follows:

1) Pay semiannual fixed dollar payments @ 8.50%, and receive variable payments based on 6-mo LIBOR, or

2) Receive semiannual fixed dollar pmts @ 8.60%, and pay variable pmts @ 6-mo LIBOR.

LIBOR cancels out (receive LIBOR = pay LIBOR) and the swap bank makes .10% or 10 bps x the amount of the swap.  10bp x $59T (swaps outstanding) = $59B annual revenue for swap banks, just in swap fees!

Other currencies are also quoted for interest rate swaps such as:

1) Bank will pay semiannual fixed SF payments @ 6.6% and receive variable 6-mo LIBOR payments, or

2) Receive fixed semiannual SF pmts @ 6.70% and pay variable @ 6-mo LIBOR.  Profit = .10% (10bp).   

The swap bank will separate and re-arrange these CFs to create a currency swap.  For example, the bank will:

1) Pay fixed rate $ pmts @ 8.50% and receive fixed rate SF pmts. @ 6.70%, or

2) Receive fixed rate $ pmts at 8.60% and pay fixed-rate SF pmts. @ 6.60%.
 

RISKS FOR THE SWAP BANK IN THE SWAP MARKET

1. Interest rate risk, from a change in interest rates before the bank finds an opposing counterparty for the other side of an interest rate swap.  Swap banks that are traders stand ready to take just one side of the swap now, then later find a client for the other side.

Example from beginning of chapter: Suppose swap bank makes deal with company B, where bank will receive 10.50% from Co. B.  They hope to find a customer like Bank A, and make fixed rate pmts of 10.375%, and the swap bank makes 12.5 bp or .125%.  If rates rise by only .5% before they finalize deal with Bank A, they would have to pay out 10.875% to Bank A (instead of 10.375%), and the swap bank would lose money.

2. Basis risk, when the floating rates are NOT pegged to the same index.  Example: One counterparty's payments are pegged to LIBOR and the other to U.S. T-Bill rate.  When the two indexes do not move perfectly together, the swap could periodically be unprofitable for the bank.

3. Ex-rate risk, like int. rate risk, from changes in ex-rates during the time it takes to offset the position with an opposing counterparty.

4. Mismatch risk, from a mismatch with respect to the size of the principal sums of the two counterparties, the maturity date or the debt service dates.  In Example 10.5, we assumed that both the German and U.S. MNCs wanted 5-year debt for $36m (€40m), and payments made on the same date.    

5. Political risk, from foreign exchange controls or taxes on capital flows, other political problems that affect the swap, resulting in loss of profits for the bank.

To facilitate trading and make the swap market more efficient, there is an intl. swap organization, International Swaps and Derivatives Association (ISDA), that acts to coordinate swap activities, disseminate information, etc.  The ISDA has developed two standard swap agreements/contracts, one for int. rate swaps and one for currency swaps, that outline the terms and conditions of a standard swap, address issues like default, early termination, etc.
 

EFFICIENCY ISSUES OF SWAPS

Issue: Does the existence of a market for swaps indicate market inefficiency?  Does the QSD (quality spread differential) imply mispricing of default risk premiums on some debt?  Does a QSD imply that there are arbitrage opportunities from exploiting interest rate discrepancies?

If QSD did represent mispricing of debt, you would expect that the swap market would disappear over time due to arbitrage.  Just the opposite has happened, the swap market has exploded.  Explanation: The credit/currency markets are efficient for securities that are traded, but there is a problem of Market Completeness - all types of debt are not always available for all types of borrowers.  Swaps are an innovative, creative way to meet the demand for unique credit needs that are not met in standard, traditional credit markets.  There are gains to trade (exchange) for both counterparties, and the swap banks create a market by acting as financial intermediaries, for a fee, to bring together the two counterparties.
 

FINAL ISSUES

1. Swaps are off-book transactions for both counterparties and the swap bank - they do not appear as either assets or liabilities on the balance sheet, they are included in the footnotes of financial reports.

2. Swaps are important source of revenue for intl. banks, e.g. $59T Interest Rate Swaps x .25% = $1.47T. 

3. Banks have to meet internationally standardized capital requirements/standards, on a risk-adjusted basis.  Guidelines are now in place for how to treat swaps, since they are off-balance-sheet activities, but can increase risk for banks.