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Admin News

Finals date: 60% liked 12/18 (Registrar-set date) .

=> So, final will be 12/18.

Some of you had emergency reasons & wound not be able to make it => expect an email from me.

Quiz V next Tuesday

If absolutely cant come, please let me know

Will try to accommodate you .

Otherwise, weight goes to final

Swaps
(or parts of chapter 14)

Agenda
Interest rate risk?

Credit & Repricing risks

What hedging strategy?

Refinancing
Forward Rate Agreement
Interest Rate Future
Interest Rate Swap
Currency Swap (& how to undo them)

Counterparty Risk

Cross Currency Swaps (again )

Interest Rate Risk


Fact: all firms sensitive to interest rate changes.
MNE: differing currencies have differing interest rates
=> interest rate risk larger!

Reference rate
rate of interest used in standardized quotation, loan

agreement, or financial derivative valuation


Most common: LIBOR (London Interbank Offered
Rate).

Credit and Repricing Risk

Credit (roll-over ) Risk: risk of change of borrower


creditworthiness when renewing credit.

Repricing risk: risk of changes in interest rates charged


(earned) when financial contract rate is reset.

For Example: three debt strategies

#1: Borrow $1 million for 3 years @ fixed rate.


#2: Borrow $1 million for 3 years @ floating rate, LIBOR + 2%
reset annually.
#3: Borrow $1 million for 1 year @ fixed rate, renew credit
annually

How to hedge floating-rate loans risk?

Assume floating-rate loan for US$10 m.

Serviced w/ annual payments

Bullet principal payment @ end third year

Loan priced @ US$ LIBOR + 1.50%.


LIBOR reset annually.
At time 0, up-front fee of 1.50%.
Do we know the actually cost?

Floating-Rate Loan: Example


3-year $10,000,000 floating rate loan
Loan Interest Rate
LIBOR
Spread
Total
Interest Cash Flows
LIBOR
Spread
Total
Loan Proceeds
Total Loan cash flow

Year 1

Year 2

Year 3

5%

5%
1.50%
6.5%

5%
1.50%
6.5%

5%
1.50%
6.5%

Year 0

Year 1
($500,000)
(150,000)
($650,000)

Year 2
($500,000)
(150,000)
($650,000)

$9,850,000
$9,850,000

IRR of total cash flow


Sensitivity to LIBOR
Baseline case
LIBOR up 25 bp/year
LIBOR down 25 bp/year

Year 0

($650,000)

Year 3
($500,000)
(150,000)
($650,000)
($10,000,000)
($650,000) ($10,650,000)

7.07%
All-in-Cost
A-I-C
7.07%
7.57%
6.58%

LIBOR (yr. 0) LIBOR (yr. 1) LIBOR(yr. 2) LIBOR (yr. 3)


5%
5%
5%
5%
5%
5.25%
5.50%
5.75%
5%
4.75%
4.50%
4.25%

How to manage a floating rate loan?


Alternatives
Refinancing refinance the entire agreement.
Forward Rate Agreement (FRA) lock in future interest
rate payment (as w/ forex forward contracts).

Interest Rate Futures


Interest Rate Swaps Could swap floating rate note for
fixed rate note w/ swap dealer.

Forward Rate Agreement (FRA)

Interbank-traded contract to buy or sell interest rate payments on


notional principal.

E.g.: If you wish to lock in first payment, buy a FRA which locks
total interest payment @ 6.5%

If LIBOR above 5% => receive cash payment from FRA seller reducing
LIBOR payment to 5%
If LIBOR below 5% => pay FRA seller cash amount increasing LIBOR
payment to 5%
So you locking in payment of 5%+1.5%!

Interest Rate Futures

Very often used (unlike forex futures)

high liquidity of interest rate futures markets


standardized interest rate exposures firms

Exchange-traded

Chicago Mercantile Exchange (CME).


Chicago Board of Trade (CBOT).
London Intl Financial Futures & Options Exchange (LIFFE).

Yield calculated from settlement price

Exposure Action

Interest
Rate

Outcome

Paying
interest

Short
future

Rates up
Rates down

Pfutures down (short: profit)

Earning
interest

Long
future

Rates up
Rates down

Pfutures down (long: loss)

Pfutures up (short: loss)


Pfutures up (long: profit)

Eurodollar Futures (3 month), 11/19/03

Source: WSJ, 11/20/03

Interest Rate & Currency Swaps

Contractual agreements to exchange (swap) series of cash flows.

Commits each counterparty to exchange amount of funds, @ regular intervals, until


expiration.

Interest rate swap: agreement to swap fixed interest payment for floating rate
payment.

Currency swap: agreement to swap currencies of debt service => initial currency
exchange & reverse @ maturity.

Swap may combine elements of both interest rate and currency swap.

Swap itself not source of capital!

Interest Rate Swaps Strategies

Swap = collection of forward contracts for exchange of funds @specified maturities.

reduces transaction costs.


legal structure of swap transaction reduce counterparty risk.

Interest rate swap cash flows: interest rates applied to a notional principal, but no
principal is swapped!

Position

Expectation

Strategy

Fixed-Rate Debt

Rates up
Rates down

Stay put
Pay floating/Receive Fixed

Floating-Rate Debt Rates up


Rates down

Pay fixed/Receive floating


Stay put

Example: swapping to fixed rates

Expect rates will rise over life of loan.

=> interest rate swap pay fixed/receive floating would be best.

Bank quotes you 5.75% against LIBOR

The swap does not replace the original loan, must still make payments
at original rates!

Swap only supplements the loan payments!

Interest Rate Swap


Loan Interest Rate

Variability

Year 1

Year 2

Year 3

LIBOR
Spread
Total

Floating
Fixed

-5.00%
-1.50%
-6.50%

-5.00%
-1.50%
-6.50%

-5.00%
-1.50%
-6.50%

Swap Cash Flows


Pay fixed
Receive floating LIBOR

Variability
Fixed
Floating

Year 1
-5.75%
5.00%

Year 2
-5.75%
5.00%

Year 3
-5.75%
5.00%

Loan & Swap Position


LIBOR on loan
Spread (fixed)
Pay fixed on swap
Receive floating LIBOR
Net interest due after swap

Variability
LIBOR (yr. 1) LIBOR(yr. 2) LIBOR (yr. 3)
Paying
-5.00%
-5.00%
-5.00%
Paying
-1.50%
-1.50%
-1.50%
Paying
-5.75%
-5.75%
-5.75%
Receiving
5.00%
5.00%
5.00%
Net Payment
-7.25%
-7.25%
-7.25%

Currency Swap

So far, raised $10m in floating rate financing & swap into fixed
rate payments.
But, may prefer to make debt-service payments in SF.
=> would enter into a 3-year pay Swiss francs & receive US$
swap

Both interest rates fixed.


Will pay 2.01% (ask rate) fixed SF interest & receive 5.56% (bid
rate) fixed US$.

Spot rate on date of agreement establishes notional principal is in


target currency

Notional amount of SF 15,000,000.


Commit to payments SF 301,500 (2.01% SF15,000,000)
The notional amounts part of swap agreement!

Currency Swap

Source: Financial Times (as quoted by MSE)

Swapping US$ to Swiss Francs

Unwinding Swaps
Can unwind a swap if viewpoints changes
Assume 3-year contract w/ Swiss buyer terminates in

one year
How to unwind it?

Discount remaining cash flows under swap agreement


@ current interest rates.

Convert target currency back to home currency

Unwinding Swaps

Assume two payments left: SF301,500 & SF15,301,500


2-year fixed rate for SF is 2%
PV swap commitment
301,500 15,301,500
1

(1.020)

(1.020)

SF15,002,912

PV of remaining cash flows on the $-side of swap is determined using current


2 year fixed dollar rate 5.5%

$556,000 $10,556,000
PV(US$)

$10,011,078
1
2
(1.055)
(1.055)

PV net inflows $10,011,078.


PV net outflows SF 15,002,912.
If current spot SF 1.465/$ net settlement

Sfr15,002,912
Settlement $10,011,07 8
($229,818)
Sfr1.4650/$

Counterparty Risk
Potential exposure any firm bears that second party to
financial contract will be unable to fulfill obligations.

A firm entering into a swap agreement retains the ultimate


responsibility for its debt-service.

In event swap counterpart defaults, payments would cease.


The real exposure: not total notional principal, but markto-market value of differentials!

3-way Cross Currency Swap


Sometimes firms enter into loan agreements w/ swap already in mind,
creating debt issuance coupled w/ swap from inception
Province of Ontario

C$300
million

(Canada)
$260
million

Borrows $390 m
@ US Treasury + 48 b.p.

$130
million

C$150
million

(Finland)

Inter-American
Development Bank

Borrows C$300 million


@ Canadian Treasury + 47 b.p.

Borrows C$150 million


@ Canadian Treasury + 44 b.p.

Finish Export Credit

Things to remember

Interest rate risk?

Credit & Repricing risks

What hedging strategy?

Refinancing
Forward Rate Agreement
Interest Rate Future
Interest Rate Swap
Currency Swap (& how to undo them)

Counterparty Risk.

Cross Currency Swaps.