This article appeared in Capital page, The Edge Malaysia, Issue 796, Mar 8-14,

2010
Financial Wizardry in Swaps – the Greek case
By Jasvin Josen

The international news bulletins in the past two weeks have been overflowing with the stories of
Greece hiding its true level of national debt. It eventually emerged that the debt was apparently
higher than advertised by around USD1billion. The instrument of choice surfaced as cross currency
swaps, which were designed specifically to enable Greece to receive huge loans that were
technically “off balance sheet” and therefore not necessarily reported.

This article will explain how such a swap could be set up to allow an undisclosed loan to end up on
the laps of the Hellenes.

What is a cross currency swap

A swap is simply an agreement between two parties to exchange (or swap) cash flows in the future.
The motivation is more often than not to hedge interest rate risk, currency risk or both.

For interest rate risk, the hedger could be a corporate or sovereign issuing a fixed-rate debt (bond
with fixed coupons, say 5% p.a.). Changes in interest rates will affect the discounting rates that are
used to value the bond in its books. The market value of the bond is simply the total present value of
its cashflows. Present value is a cashflow in a particular year divided by its discount rate. For
example say the coupon of $100 will be received in Year 2. We have to value this part of the
cashflow today in terms of its present value. Assume forward interest rates indicate Year 2 interest
rate at 4.0%. The discount rate for Year 2 will hence be 1/(1+ 0.04)2 =0.925 and the present value of
the coupon would be $100*0.925=$92.5. The fixed rate bond issuer is exposed to interest rate risk.
Observe that as interest rates increase, the discount rate will fall and so will the present value of the
bond.

Issuers have the option to issue floating rate bonds (coupons that go up and down with the changes
in interest rates) which will counter the changes in discount rates and consequently result in minimal
changes to the bond value. However in some cases, the floating rate notes tend to be less appealing
to investors. The way out for the fixed rate bond issuer is to then enter into an interest rate swap
where the fixed rate coupons can be exchanged with floating rate coupons. Effectively the issuer is
issuing a floating rate bond with hardly any interest rate risk.

For currency risk, the corporate or sovereign probably has issued a foreign debt paying coupons in a
foreign currency. For instance Greece issued a sovereign bond in USD but needed EUR to pay for its
expenses. Greece was exposed to currency risk as it had to exchange Euros into USD to pay the
future coupons and the principal at maturity.

Greece could hedge this currency risk by entering into a currency swap to transform the currency of
its bond from USD into EUR.
Chart 1 – Currency Swap

Inception Government Debt Currency Swap

USD Greece USD

Investors
Swap
Counterpaty
EUR
Coupons
USD coupons USD coupons

EUR coupons
Maturity
USD USD

EUR

In Chart 1 above, Greece simply passes the USD proceeds received from bondholders to the Swap
Counterparty (usually a financial institution) in return for EUR proceeds at the prevailing exchange
rate. The bond coupons will be paid in USD to bondholders which will come from the swap
counterparty. Greece will pay EUR coupons to the swap counterparty. At maturity Greece will pay
the USD principal back to the bondholders which will again be switched into EUR with the swap. It is
as though Greece has issued a EUR bond.

Valuation of a Cross Currency Swap

Frequently the currency swap is combined with an interest rate swap to form a cross currency swap.
Here, floating (or fixed) foreign cashflows could be swapped with fixed (or floating) domestic
cashflows. Pricing the swap is basically like valuing two separate bonds with cashflows in opposite
directions. In the Greek case above, it would be the present values (PVs) of the USD ‘bond’ and the
EUR ‘bond’. The foreign USD PV is converted to EUR by multiplying it with the spot exchange rate.

[PV(USD cashflows) x Spot USD/EUR ] – PV (EUR cashflows)

When a spot exchange rate is used and the fixed coupon rate (swap rate) makes the PV of the swap
zero at inception, the swap is an at-market swap. The PVs will subsequently be positive or negative
as the swap matures, depending on the interest rate and exchange rate movements. We will see a
detail worked out example later.

The Greek Case

We now examine the Greek case to see how Greece managed to get an “off balance sheet” loan
using a cross currency swap. The details are gathered from various news sources, and a hypothetical
example is then put forward.

A comparison between a normal cross currency swap and the one that Greece transacted is
illustrated in Table below:

Table

Feature Normal Cross Currency Swap Greece’s case

Market Swap At-market swap (Par swap) Off-market swap (Non par swap)
Value at inception Zero Positive (to Greece)

Neither party needs to make an Swap counterparty makes an

Upfront payment
upfront payment upfront payment to Greece

Exchange rate used for valuation

Spot (market) rate Fictitious rate
of swap

Interest payments deferred on the

Consistent payments throughout EUR leg resulting in balloon
Interest payments
the swap period payments payable nearing the
maturity of the swap

The currency swap issued in the Greek case was an “off-market” swap. The spot exchange rate was
not used to re-denominate the cashflows of the foreign leg at the inception of the swap. This caused
the PV not to be zero but significantly positive to Greece. Further, the interest rates payable by
Greece to the swap counterparty were deferred to ease the burden in the earlier years. The effect of
this was to create an upfront payment by the swap counterparty to Greece at inception. The swap
counterparty would recoup these non-standard cashflows at maturity, receiving a large ‘balloon’
cash payment from Greece.

I will illustrate with an example with some numbers.

Chart 2 - At-market swap

EUR rate (flat term structure) 3%
USD rate (flat term structure) 4%

A B C D E

Receive Pay
Year USD m PV(USD) EUR PV (EUR)
0 -1200 -1200 1000 1000 (Note 1)

1 72 69.23 48.02 46.63

2 72 66.57 48.02 45.27
3 72 64.01 48.02 43.95
4 72 61.55 48.02 42.67
5 72 59.18 48.02 41.43
6 1200 948.38 1000.00 837.48
1268.91 1057.42

Swap rate: 4.80%

Spot FX rate (EUR/USD) 0.833
Val of Swap at inception 0

Note 1: At inception, the exchange of two notionals at the spot exchange rate
is said to be fair
Chart 2 shows an at-market swap at inception. Column B shows the cashflows (principal and
coupons) of the foreign (USD) leg. Column C shows the PV of these cashflows, discounted at the USD
rate of 4% assuming a flat term structure of interest rates. In column D we have the EUR (domestic)
leg and in column E, the PV of those cashfows discounted at the EUR rate of 3%. The spot (market)
exchange rate of [USD1=EUR0.8] is used to value the swap and make the initial notional exchange.
The swap rate (effectively the fixed rate on the EUR leg) that would make the PV zero is worked out
to be 4.80% (48/1000)

Now, the same swap adopted in the Greek case will look like the following:

Chart 3 - Off the market swap

EUR rate (flat term structure) 3%
USD rate (flat term structure) 4%

A B C D E

Receive Pay
Year USD m PV (USD) EUR PV (EUR)
0 -1200 -1200 1000 1000 (Note 1)

1 72 69.23 30 29.13
2 72 66.57 30 28.28
3 72 64.01 30 27.45
4 72 61.55 30 26.65
5 72 59.18 120.12 103.62
6 1200 948.38 1080 904.48
1268.91 1119.62

Swap Rate: Non existent

Fictional FX rate (EUR/USD) 0.900
Val of Swap at inception 22 +ve PV to Greece

Note that the fictional exchange rate of 0.9 instead of 0.833 is used. Coupons were designed to be
lighter in the earlier years to provide some breathing space. Instead of having a swap rate to make
the PV zero at inception, coupons and exchange rates seem to have been worked backwards to
enable the swap to have a positive PV that results in an upfront payment to Greece.

The swaps are said to have been done around 2001 with long maturities of around 15-20 years.
Balloon payments outwards close to the maturity of the swap would have very low PVs as discount
rates get higher with longer maturities. Big inflows in the beginning (high positive PVs) and big
outflows at the end (low negative PVs) will easily give a positive PV for Greece at inception.

The upfront payment was hidden from public view as the amount could be treated as a currency
trade rather than a loan. This credit disguised as a swap did not show up in the Greek debt statistics.
Eurostat’s reporting rules do not comprehensively record transactions involving derivatives.
Back in 2003, author Nick Dunbar had already smelt danger and highlighted his concern in the Risk
Magazine, July 2003. He warned about the loopholes in the Europe reporting rules. Information
sources state that only in March 2008 Eurostat changed the rules allowing a debt swapped into
another currency using an off-market rate to be regarded as two components – an at-the-market
swap and a loan from the swap counterparty – with the latter included in government debt.

Conclusion

Greece seemed to be in a tight spot early of the century. There was pressure to keep national debts
low to meet the European Union targets. Around then Greece also hosted the 2004 Olympics which
would have incurred huge preparation costs. It is no surprise that some financial wizardry was
urgently needed. After all, derivatives are very flexible instruments.