Chapter 14
Interest rate and Currency swaps:
Financial risks: 1. Exchange rate
2. Interest rate
3. Commodity prices
influence on cash flow of Multi-National Corporations
Interest rates are currency-specific: each currency has its Interbank interest rate market.
? LIBOR: London Interbank Offered Rate
? PIBOR: Paris Interbank Offered Rate
? MIBOR: Madrid Interbank Offered Rate
? SIBOR: Singapore Interbank Offered Rate
? FIBOR: Frankfurt Interbank Offered Rate
? British Bankers Association (BBA) calculates LIBOR of US dollar, Japanese yen, euro and other currencies from means of interbank offered rates of samples of multinational banks, at approximately 11 a.m. London time.
? LIBOR is used in standardised quotation, loan agreement or financial derivatives.
? A firm will pay/earn the interest rate of LIBOR + Spread, which is company- specific.
Risks of interest rates:
? Credit risk / roll-over risk: when lenders and borrowers renew a credit. E.g. changing fees, changing interest rate, altered credit line commitments, or denial.
? Repricing risk = changes in interest rates charged (earned) at the time a financial contract's rate is reset.
Three debt strategies to finance $1 million for a three-year period.
1. Borrow $1 million for three years at fixed rate of interest = cash-flow is predictable with sacrificing the ability to enjoy lower interest rate. no credit/repricing risk.
2. Borrow $1 million for three years at a floating rate, LIBOR +2%, to be reset annually = no credit risks, but the interest rates could go up as well as down.
3. Borrow $1 million for one year at a fixed rate, then renew the credit annually = flexibility as well as risks.
To manage interest rate risks associated with the loan agreement.
? Refinancing
? Forward rate agreement
? Interest rate futures
? Interest rate swaps
Forward Rate Agreement (FRA):
The buyer of an FRA obtains the right to lock an interest rate for desired term. The seller of the FRA will pay the buyer the increased interest expense on a nominal sum/principal of money, if interest rate rise above the agreed rate. The seller will receive the differential interest expense if interest rates fall below the agreed rate.
Interest rate futures:
Unlike foreign currency futures, it is relatively popular because of liquidity of the markets. The two most widely used futures contracts are
? Eurodollar futures traded on the Chicago Mercantile Exchange
? US Treasury Bond Futures of the Chicago Board of Trade
By selling the future contract or taking a short position, floating interest rate is fixed.
Interest rate swaps:
are contractual agreement to exchange or swap a series of cash flow.
? Fixed interest rate payment to floating interest rate payment
? U.S. dollar interest rate payment to Japanese yen interest payment = currency swap. //A single swap can be both of interest rate and currency swap.
? The swaps do not cover company specific spread, so the swap market does not differentiate the rate by participants.
Example: Oregon State University- Ecuadorian government.
1. Ecuadorian government wants to reduce its US dollar debts with preventing devaluation of its currency; sucre.
2. Oregon State University wants Ecuadorian sucre for study programs there.
3. Oregon State University purchase the Ecuadorian debts in US dollar.
4. It swaps interest earning in US dollar to in Ecuadorian sucre.
This program is applicable only to non- profit organization that will not sell sucre.
Example 2:
Three year pay Swiss francs and receive U.S. dollar currency swap.
? A will pay fixed Swiss franc interest rate of 2.01%, excluding the spread.
? B will pay fixed U.S. dollar interest rate of 5.56%, excluding the spread.
￢ Exchange rate is spot on the date of agreement establishes what the notional principal is.
￢ The notional principal itself is part of the swap agreement. *there is no need to include the principal in the agreement.
￢ The net present values of both payments are the same.
year 0 Payment
Principle Interest rate
SWAP year 1 year 2 year 3
A $10 million 5.56% F301,500 F301,500 F15,301,500
B F15 million 2.01% $556,000 $556,000 $10,556,000
o Throughout the swap's life, both party have to regularly track and value its position, mark-to-market the swap, on the basis of current exchange rates and interest rates, as financial accounting practices.
￢ If Swiss franc appreciates versus the dollar, A will record a loss, and B will record a gain, for accounting purposes.
￢ If interest rate in the francs rises, because A's payment is fixed, A will record a gain, for accounting purposes.
Unwinding the swap: If a partner wishes to terminate the agreement before it matures. *It is non-amortized loan that firms repay the entire principal at maturity.
￢ It requires the discounting of the remaining cash flow, at current exchange rate and current fixed interest rate for a remaining period.
￢ An offering firm will pay the net settlement as replacement costs to the other, to terminate the swap.
If it is terminated the end of first year, when spot exchange rate is F1.4650/$, and two-year fixed interest rate for the franc is 2.00% and for the dollar is 5.50%
￢ PV(F) = 301,500/(1.020) + 15,301,500/(1.020)2 = F15,002,912
￢ PV($) = 556,000/(1.055) + 10,011,078/(1.055)2 = $ 10,011,078
￢ F15,002,912 ÷ 1.4650 = $ 10,240,896
Settlement = $10,240,896 - $10,011,078 = $229,818
Three-way, Back-to-back, Cross-currency Swap:
? X borrows NZ$300 million at Kiwi Treasury +47 basis points, and it wants US$260 million.
? Y borrows NZ$150 million at Kiwi Treasury +44 basis points, and it wants US$130 million.
? Z borrows US$390 million at U.S. Treasury +48 basis points, and it wants NZ$450.
Counterparty Risk:
The second party to any financial contract may be unable to fulfil its obligations under the contract's specifications. In the event that swap counterparty does not make the payment as agreed, the firm legally holding the debt is still responsible for debt service. In the even, of such a failure, the euro payments would be stopped, by the right of offset (juxtaposed obligation), and the loss associated with the failed swap would mitigated.
￢ Most exchanges have the counterparty risks to all transactions because of its high confidences.
￢ Over-the-counter trades have less counterparty risks, because the counterparty is likely the largest or soundest financial institutions.
Interest rate and Currency swaps:
Financial risks: 1. Exchange rate
2. Interest rate
3. Commodity prices
influence on cash flow of Multi-National Corporations
Interest rates are currency-specific: each currency has its Interbank interest rate market.
? LIBOR: London Interbank Offered Rate
? PIBOR: Paris Interbank Offered Rate
? MIBOR: Madrid Interbank Offered Rate
? SIBOR: Singapore Interbank Offered Rate
? FIBOR: Frankfurt Interbank Offered Rate
? British Bankers Association (BBA) calculates LIBOR of US dollar, Japanese yen, euro and other currencies from means of interbank offered rates of samples of multinational banks, at approximately 11 a.m. London time.
? LIBOR is used in standardised quotation, loan agreement or financial derivatives.
? A firm will pay/earn the interest rate of LIBOR + Spread, which is company- specific.
Risks of interest rates:
? Credit risk / roll-over risk: when lenders and borrowers renew a credit. E.g. changing fees, changing interest rate, altered credit line commitments, or denial.
? Repricing risk = changes in interest rates charged (earned) at the time a financial contract's rate is reset.
Three debt strategies to finance $1 million for a three-year period.
1. Borrow $1 million for three years at fixed rate of interest = cash-flow is predictable with sacrificing the ability to enjoy lower interest rate. no credit/repricing risk.
2. Borrow $1 million for three years at a floating rate, LIBOR +2%, to be reset annually = no credit risks, but the interest rates could go up as well as down.
3. Borrow $1 million for one year at a fixed rate, then renew the credit annually = flexibility as well as risks.
To manage interest rate risks associated with the loan agreement.
? Refinancing
? Forward rate agreement
? Interest rate futures
? Interest rate swaps
Forward Rate Agreement (FRA):
The buyer of an FRA obtains the right to lock an interest rate for desired term. The seller of the FRA will pay the buyer the increased interest expense on a nominal sum/principal of money, if interest rate rise above the agreed rate. The seller will receive the differential interest expense if interest rates fall below the agreed rate.
Interest rate futures:
Unlike foreign currency futures, it is relatively popular because of liquidity of the markets. The two most widely used futures contracts are
? Eurodollar futures traded on the Chicago Mercantile Exchange
? US Treasury Bond Futures of the Chicago Board of Trade
By selling the future contract or taking a short position, floating interest rate is fixed.
Interest rate swaps:
are contractual agreement to exchange or swap a series of cash flow.
? Fixed interest rate payment to floating interest rate payment
? U.S. dollar interest rate payment to Japanese yen interest payment = currency swap. //A single swap can be both of interest rate and currency swap.
? The swaps do not cover company specific spread, so the swap market does not differentiate the rate by participants.
Example: Oregon State University- Ecuadorian government.
1. Ecuadorian government wants to reduce its US dollar debts with preventing devaluation of its currency; sucre.
2. Oregon State University wants Ecuadorian sucre for study programs there.
3. Oregon State University purchase the Ecuadorian debts in US dollar.
4. It swaps interest earning in US dollar to in Ecuadorian sucre.
This program is applicable only to non- profit organization that will not sell sucre.
Example 2:
Three year pay Swiss francs and receive U.S. dollar currency swap.
? A will pay fixed Swiss franc interest rate of 2.01%, excluding the spread.
? B will pay fixed U.S. dollar interest rate of 5.56%, excluding the spread.
￢ Exchange rate is spot on the date of agreement establishes what the notional principal is.
￢ The notional principal itself is part of the swap agreement. *there is no need to include the principal in the agreement.
￢ The net present values of both payments are the same.
year 0 Payment
Principle Interest rate
SWAP year 1 year 2 year 3
A $10 million 5.56% F301,500 F301,500 F15,301,500
B F15 million 2.01% $556,000 $556,000 $10,556,000
o Throughout the swap's life, both party have to regularly track and value its position, mark-to-market the swap, on the basis of current exchange rates and interest rates, as financial accounting practices.
￢ If Swiss franc appreciates versus the dollar, A will record a loss, and B will record a gain, for accounting purposes.
￢ If interest rate in the francs rises, because A's payment is fixed, A will record a gain, for accounting purposes.
Unwinding the swap: If a partner wishes to terminate the agreement before it matures. *It is non-amortized loan that firms repay the entire principal at maturity.
￢ It requires the discounting of the remaining cash flow, at current exchange rate and current fixed interest rate for a remaining period.
￢ An offering firm will pay the net settlement as replacement costs to the other, to terminate the swap.
If it is terminated the end of first year, when spot exchange rate is F1.4650/$, and two-year fixed interest rate for the franc is 2.00% and for the dollar is 5.50%
￢ PV(F) = 301,500/(1.020) + 15,301,500/(1.020)2 = F15,002,912
￢ PV($) = 556,000/(1.055) + 10,011,078/(1.055)2 = $ 10,011,078
￢ F15,002,912 ÷ 1.4650 = $ 10,240,896
Settlement = $10,240,896 - $10,011,078 = $229,818
Three-way, Back-to-back, Cross-currency Swap:
? X borrows NZ$300 million at Kiwi Treasury +47 basis points, and it wants US$260 million.
? Y borrows NZ$150 million at Kiwi Treasury +44 basis points, and it wants US$130 million.
? Z borrows US$390 million at U.S. Treasury +48 basis points, and it wants NZ$450.
Counterparty Risk:
The second party to any financial contract may be unable to fulfil its obligations under the contract's specifications. In the event that swap counterparty does not make the payment as agreed, the firm legally holding the debt is still responsible for debt service. In the even, of such a failure, the euro payments would be stopped, by the right of offset (juxtaposed obligation), and the loss associated with the failed swap would mitigated.
￢ Most exchanges have the counterparty risks to all transactions because of its high confidences.
￢ Over-the-counter trades have less counterparty risks, because the counterparty is likely the largest or soundest financial institutions.