bài giảng môn tài chính quốc tế interest rate swap and currency swap

Introduced by
Assoc. Pr. Dr. Truong Quang Thong
The Faculty of Banking – UEH
August 2012
INTERNATIONAL FINANCE
TÀI CHÍNH QUỐC TẾ
Lecture 7:
Interest Rate and
Currency Swaps
1
Overview

Defining interest rate risk.

Examining its management including
credit risk and repricing risk.

Illustrating floating rate loan case
and expalining how it can be
managed
with forward rate agreement,
interest future and interest rate swap.

Introducing currency swap case
2
Interest rate risk

All firms are sensitive to interest rate movements in one way to
another.

Debt structure of large firms are very complicated:


Different maturities

Different interest rate structures

Different currencies of denomination

Holding of interest-sensitive securities

Marketable securities porfolio on the left-hand side of the BS.

Representing potential earnings or interest inflows
3
The Management Dilemma

The balance of risk
and return

The role of treasury:

Cost center?

Profit center?
4
Credit Risk and Repricing Risk

Credit risk or roll-over risk,
is the possibility that a
borrower’s credit
worthiness, at the time of

renewing a credit, is
reclassified by the lender.

Repricing risk: is the risk of
changes in interest rates
charged (earned) at the time
a financial contract ‘s rate is
reset.
5
An example of debt strategies – The same intention to provide $1 million in
financing for 3 year period

Strategy 1: borrow $1 million for
3 years at a fixed rate of interest.

Strategy 2: borrow $1 million for
3 years at floating rate,
LIBOR+2%, to be reset annually.

Strategy 3: borrow $1 million for
1 year at fixed rate, then renew
the credit annually.
6
7
Loan interest rate Year 0 Year 1 Year 2 Year 3
Libor (floating) 5.00% 5.00% 5.00% 5.00%
Spread (Fixed) 1.50% 1.50% 1.50%
Total interest payable 6.50% 6.50% 6.50%
Interest CFs on Loan
Libor (floating) (500.000) (500.000) (500.000)

Spread (Fixed) (150.000) (150.000) (150.000)
Total interest (650.000) (650.000) (650.000)
Loan proceeds (Repayment) 9.850.000 (10.000.000)
Total Loan Cash Flows 9.850.000 (650.000) (650.000) (10.650.000)
IRR of Total Cash Flows 7.072% (AIC)
Sensitivities to Libor Libor (Y0) Libor (Y1) Libor (Y2) Libor (Y3)
AIC
Baseline case above 5.00% 5.00% 5.00% 5.00% 7.072%
Libor rises 25bp / year 5.25% 5.50% 5.75% 7.565%
Libor falls 25bp/ year 4.75% 4.50% 4.25% 6.578%
Carlton’s Floating Rate Case – Loan of $10 millions with 1.5% up-front fee. Annual interest payment.
Total principal repayment at the end of 3 year period
8
Management Alternatives

Refinancing

Forward Rate
Agreement (FRA)

Interest Rate Future

Interest Rate Swaps
9
Forward rate agreement (FRA)

FRA is an interbank-traded contract to buy or sell
interest rate payment on a notional principal.

The buyer obtains the right to lock in an interest rate

for a desired term that begins at a future date

The seller will pay the buyer the increased interest
expense on a nominal sum (the notional principal) of
money if interest rates rise above the the agreed rate,
and vice versa…
10
Example

The borrower wishes to lock in the first interest
payment (due at the end of year 1): buy an FRA
that locks in a total interest payment of 6.5%.

If LIBOR rises above 5% by the end of year 1 ?

If LIBOR falls below 5% ?
11
Interest Rate Future

Relatively widely used by high liquidity, simplicty in
use.

The two most widely used future contracts:

Eurodollar futures traded on the CME

US Treasury Bond Futures of CBOT.
12
Example: Typical presentation by the WSJ. Only regular quartely
matutities are shown. All contracts are for $1 million. Points of 100%.

Open interest is number of contracts outstanding.
Eurodollar Futures Prices
MATURITY Open High Low Settle Yield Open
Interest
June 02
94.99 95.01 94.98 95.01 4.99 455,763
Sept
94.87 94.97 94.87 94.96 5.04 535,932
Dec
94.60 94.70 94.60 94.68 5.32 367,036
Mar 03
94.67 94.77 94.66 94.76 5.24 299,933
June
94.55 94.68 94.54 94.63 5.37 208,949
Sept
94.43 94.54 94.43 94.53 5.47 168,961
Dec
94.27 94.38 94.27 94.36 5.64 130,824
13
Example

Quotes for March 2003: yield = 100.00-94.76 =
5.24%

If Carlton were interested in hedging a floating-rate
interest payment due in March 2003  sell a future

So, locking in an interest rate of 5.24%

If interest rate rise by Marche 2003?


If interest rate fall by Marche 2003?
14
Interest Rate Futures Strategies for Common Exposures
Exposure or Position Futures Actions Interest
Rate
Position
Outcome
Paying interest on
future date
Sell a future (Short
position)
If rates go
up
Future price
fall; short
earns a profit
If rates go
down
Future price
rises; short
earns a loss
Earning interest on
future date
Buy a future (Long
position)
If rates go
up
Future price
fall; long

earns a loss
If rates go
down
Future price
rises; long
earns a profit
15
Interest Rate Swaps

Swaps are contractual agreements to exchange or swap a
series of cash flows commonly including interest and debt
service, such as the floating rate loan.

If to swap its fixed interest rate payment for the floating interest
rate payments of another: interest swap

If to swap currencies of debt service obligation: currency swap

A single swap may combine element of both interest rate and
currency swaps.

Plain Vanilla Swap
: agreement between tow parties to exchange
fixed for floating rate financial obligation
16
Interest Rate Swap Strategies
Position Exppectation Strategy
Fixed rate debt Rates to go up Do nothing
Rates to go down Pay
floating/Receive

fixed
Floating rate debt Rates to go up Pay fixed/Receive
floating
Rates to go down Do nothing
17
Interest Rate Swaps - Example

Carlton ‘s existing floating rate loan is now the source
of some concerns (loan of $10 millions at Libor+2%).

It worries that Libor may be rising in three years
ahead.

It believes that a pay fixed/receive floating interest
swap may be a better alternative for fixing future
interest rate now.

It is quoted by a bank a fixed rate of 5.75% against
Libor
18
Carlton’s Interest rate swap to pay fixed / receive floating
Loan interest rate Variability Year 1 Year 2 Year 3
LIBOR (floating)) Could go up or down -5.00% -5.00% -5.00%
Spread (fixed) Fixed -1.5% -1.5% -1.5%
Total interest payable -6.50% -6.50% -6.50%
SWAP INTEREST RATE
Pay fixed Fixed -5.75% -5.75% -5.75%
Receive floating Libor Could go up or down +5.00% +5.00% +5.00%
COMBINED LOAN AND SWAP POSITION
LIBOR ON LOAN Paying -5.00% -5.00% -5.00%

Spread (fixed) Paying -1.50% -1.50% -1.50%
Pay fixed on swap Paying -5.75% -5.75% -5.75%
Receiving floating Libor
on swap
Receiving +5.00% +5.00% +5.00%
Net interest due after
swap
Net payment -7.25% -7.25% -7.25%
Is this a good deal for Carlton?
19
Currency Swap

Motivation: to replace
cash flows scheduled in
an undesired currency
with flows in a desired
currency.

Utility is significant for
MNSC
20
Currency Swap - Example

After raising $10 million in floating rate financing and
subsequently swapping into fixed rate payments, Carlton
decides that it would prefer to make its debt service
payment in Swiss francs.

Carlton had recently signed a sales contract with a Swiss
buyer that will be paying francs to Carlton over the next

three year period.

It wishes to match the currency of denomination of the cash
flows through a currency swap.
21
Pay Swiss Francs and Receive US Dollars
SWAP component Year 0 Year 1 Year 2 Year 3
Will receive fixed US$ at this
rate
5,56% 5,56% 5,56%
on a notional principal of 10.000.000USD
Cash Flow received 556.000USD 556.000USD 10.556.000USD
Exchange rate CHF1,50/USD
Will pay fixed CHF at rate: 2,01% 2,01% 2,01%
On a notional principal of 15.000.000CHF
Cash Flow Carlton will pay 301.500CHF 301.500CHF 15.301.500CHF
22
Observation

At the time of the Swap’s inception

Gain or loss throughout the Swap’s life

Nonamortizing Swap vs Unwinding Swap.