FIN30014 – Financial Risk

Management
Topic 9
Interest Rate & Currency Swaps
Reading:
Hull, Ch 7 (pp. 158 – 170, 178 - 182)
Session Objectives
1. To understand the nature and characteristics of:
a. Interest rate swaps, and
b. Currency swaps
2. To understand how these swaps work and the
reasons why firms enter into them
3. To understand the importance of being able to
price and value swaps
4. To be familiar with strategies for using swaps
Interest Rate and
Foreign Currency Swaps
 Swaps are derivative contracts in which two
parties agree to exchange a series of
specified cash flows at specified future dates.
 Swaps can be used to:
 reduce borrowing costs
 manage interest rate risk exposure
 manage foreign exchange risk exposure
Interest Rate and
Foreign Currency Swaps (cont)
Key Point
 Swaps enable entities to separate
decisions about:
 which market to borrow funds in?
 which interest rate basis (fixed or floating)?
 which currency to borrow in?
Interest Rate Swaps

 An agreement between two parties where each

party agrees to exchange a series of interest
rate payments on specified dates,
and
 where at least one set of payments is
determined by a variable (floating) interest rate.
Floating Reference Rates
 Australia
 Floatingrate is usually the Australian Bank Bill
Swap Rate (BBSW)
 As noted in Topic 4, these bills are bank
accepted so accepted as reflecting bank risk
 International Interest Rate Swaps
 LIBOR is most commonly used
 1, 3, 6, 12, month LIBOR rates are commonly
quoted for all major currencies
 The Role of the Financial
Intermediary in Interest rate Swaps

 The first swap contracts were arranged directly between two

firms seeking to achieve a desired position
 Later, banks came to intermediate between two firms seeking to
enter into offsetting swaps.
 The usual reason for the swap was to exploit market
imperfections and so lower borrowing costs to both parties.
Interest Rate Swap examples

Party A Party B

Vanilla IRS Pays fixed rate, Pays floating rate,

Receives floating rate Receives fixed rate

Basis Swap, Pays USD LIBOR, Pays GBP LIBOR,

Example 1 Receives GBP LIBOR Receives USD LIBOR

Basis Swap, Pays 1 month USD LIBOR, Pays 6 month USD LIBOR,
Example 2 Receives 6 month USD LIBOR Receives 1 month USD LIBOR
Plain Vanilla Interest Rate Swap Cash Flows

Pay LIBOR (floating rate)

Citibank, CBA
New York Pay Fixed Interest 3.0% Sydney

• LIBOR rate is determined by 3 month LIBOR at the

beginning of each settlement period
• The payments at end of each settlement period are:
$50,000,000*(LIBOR – 0.03)* (Days/360)
• Payments are netted so only the difference is paid
Typical Structure of an Interest Rate Swap
Notional Principal $10mil, $25 mil, $50 mil, etc

Start date Specific start date

Payment dates Monthly, quarterly, bi-annually, etc at a pre
specified payment date
Reference rate LIBOR, BBSW, SIBOR, etc for floating
Pre-determined fixed rate
Maturity date When the contract ends
Day count fraction actual/365, actual/360, actual/actual,
30/360,180/365, etc
Counterparty A Pays fixed rate, receives floating rate
Counterparty B Pays floating rate, receives fixed rate
Settlement Net settlement of floating and fixed rates
Example – Vanilla Interest Rate Swap
Citibank New York Commonwealth Bank
Sydney
Notional USD 50,000,000
Payment period Quarterly, starting June 15th
Maturity In 2 years
Terms Pays LIBOR to CBA Pays 3.0% fixed to Citibank
Reference rate 3 month USD LIBOR
Day count fraction Actual / 360
Settlement Net settlement of the above
If LIBOR at 15th June is 2.5%
Outcome No payment Pays net 0.5% (3.0% – 2.5%)
to Citibank
Actual settlement 0.5% x 50,000,000 x 91/360 =USD 63,194
Note : 91 days being the actual number of days between
April and June
The Role of Absolute vs Comparative
Advantage Concepts in Swap Construction
 Absolute Advantage
 Cheaper cost of borrowing for all possibilities or
 Higher returns to investment for all possibilities
 Eg. A company with a higher credit rating can get
cheaper cost of borrowing for all product types

 Comparative Advantage
 Least opportunity cost incurred by taking that
alternative or
 Greatest difference in savings or returns to

investment earned by taking that alternative

Example
 Assume the following borrowing opportunities and that
A wants to borrow fixed rate and X wants to borrow
floating rate

Fixed Floating
A Ltd 8.4% 3 month LIBOR + 0.6%

X Ltd 7.5% 3 month LIBOR + 0.3%

 How do you construct an interest rate swap between
the parties?
Steps in constructing a swap

1. Ascertain if the situation relates to borrowing costs or

investment returns

2. Identify if any party has absolute advantage

3. For the party that has absolute advantage, identify for which financial
instrument type does it has comparative advantage in. The party will
then invest or borrow that particular financial instrument. The other
party will invest or borrow in the other financial instrument type.
4. Calculate the net difference between comparative advantages. This
will be the net savings
5. Put aside the intermediary’s share of the savings, if any
6. Split any left over savings between the counterparties equally, or as
per their agreement
7. Construct the swap
Steps in constructing a swap

1) This is a borrowing situation

2) X can borrow at lower rate for both fixed and floating hence
X has Absolute Advantage in borrowing

A Limited X Limited Difference in rates

Fixed 8.4% 7.5% 8.4 - 7.5 =0.9%
Floating LIBOR + 0.6% LIBOR + 0.3% 0.6-0.3 = 0.3%

3)
For X, savings on fixed is 0.9% while savings on floating rate is 0.3%.
Hence X has comparative advantage in borrowing at fixed rate.
X will borrow at fixed rate while A will then borrow in floating rate
Steps in constructing a swap

4) Net Difference in savings 0.9 – 0.3 = 0.6%

A Limited X Limited Intermediary Bank

5) Bank requires 0.2% 0.2%

6) 0.6-0.2 = 0.4, 0.2% 0.2%
divide 0.4 between
A & X equally
7) Outcome of Swap Borrows Floating Borrows fixed at 7.5% Bank earns 0.2%
at LIBOR + 0.6% , Pays intermediary
Pays intermediary LIBOR + 0.3 - 0.2 =
fixed - 0.2% LIBOR +0.1%
8.4 - 0.2 = 8.2%
By going into a SWAP,
A saves 0.2% on the fixed side,
X saves 0.2% from the floating side and
Intermediary bank gains 0.2% for bearing risk
 Plain Vanilla Interest Rate Swap Cash
flows with Financial Intermediary
X Receives fixed interest A Pays fixed
at 7.5% from bank interest at 8.2% to
Bank earns 0.7%
bank, saves 0.2%
(8.2-7.5) from fixed
X Ltd interest flow A Ltd
Bank loses 0.5%
(0.1-0.6) from
X Pays LIBOR floating interest A Receives
+ 0.1% to bank, flows LIBOR + 0.6%
Saves 0.2% Net gain of 0.2%

Arrows signify the flow of

Borrow Borrow
externally at interest payments between externally at
fixed rate of LIBOR + 0.6%
parties
7.5%
 Criticism of the “CA” argument
 Why should the spreads differ between floating and fixed
rate markets for different firms?
 Shouldn’t swap market arbitrage eradicate this?
 The reason why spread differentials may continue to exist
lies in the fact that fixed rates are quoted for a longer time
period (e.g. 3 to 5 years) while LIBOR rates are quoted for,
say, 3 to 6 months
 In floating rate markets the lender can usually review the
floating rates at rollover date (not so for fixed rates)
 If creditworthiness of the floating rate borrower decreases
then will pay a higher spread over LIBOR
 So, observed differentials may reflect default risk!
Criticism of the “CA” argument (cont)
 In our example, if A borrows at LIBOR + 0.6% and
enters into the swap to pay fixed at 8.2%
 However, this only continues to be the case if A can
continue to borrow from banks at LIBOR + 0.6% at each
rollover date over the life of the swap.
 If A’s credit rating deteriorates it may end up paying
substantially more than LIBOR + 0.6%
 For example, if it ends up paying LIBOR + 1.4% then its
borrowing costs increase to 9% (fixed payments of 8.2%
plus an additional 0.8% on its LIBOR based loan) which
is higher than the 8.4% fixed rate it could have borrowed
at initially.
PLEASE TAKE NOTE!
 Swaps are NO LONGER organised in the manner depicted
in our example (which was used to illustrate the
comparative advantage argument).
 Instead, banks act as market makers for swaps.
 Market makers quote ‘bid’ and ‘offer’ fixed rates usually at
a spread of about 3 to 5 basis points (see Hull, Table 7.3)
 Quotes will reflect the forward interest rate yield curve
 Banks deal with counterparties seeking a swap on a ‘one
to one basis’ rather than as an intermediary between two
parties as depicted in the example.
 The CA argument reason for a swap may still be valid
Why do Companies Enter into a Swap?
1. Reducing borrowing costs

2. Alter the fixed / floating rate proportions of its loans to accord with
i. risk management objectives, and
ii. management’s view on future rate movements

3. Transform financial assets from floating rate investments to fixed rate or

vice-versa.

4. Strategies (2) and (3) are used by banks to adjust the fixed/floating profiles
of their asset and liability portfolios to a desired level.
Valuing Interest Rate Swaps
 An interest rate swap is basically a series of FRAs
and like all forwards has a zero value at inception.
 Subsequently, its value may become positive or
negative to each party as interest rates change
 Valuation methods based on (1) bond prices and (2)
FRAs are discussed in the text (not required
knowledge for assessment purposes).
 Obviously, the value of the swap to both parties will
change with changes in the term structure of LIBOR
rates (the floating rate)
 Valuing swaps is necessary to properly monitor and
manage swaps and also for financial reporting.
Foreign Currency Swaps
 Involve an exchange of obligations in different
currencies for both interest streams and
(usually) the principal sums.
 Where counterparties exchange principals at
inception they reverse exchange at maturity at
the same exchange rate as at the inception of
the swap.
 Swap payments of interest are in different
currencies so they are not netted.
 Foreign Currency Swaps
A Simplified “Comparative Advantage’ Example*
 An Australian firm wishes to expand its operations into the
USA at a cost of US$20m to be financed by borrowing.
 Because the firm’s income will be in USD, the firm prefers
to make interest payments in USD.
 Also, a US firm wishes to borrow and invest A$25m in
Australia and wishes to make interest payments in AUD.
 The current exchange rate is per A$1 = US$0.80
Foreign Currency Swaps (cont)
 Companies often enjoy a comparative advantage in
their domestic markets because local financial
markets are more familiar with their credit risk and
charge a lower risk premium.
 Assume Aus Co. and US Co. can borrow at the following
fixed rates of interest:

In Australia In US

Aus Co. 8.0% 7%

US Co. 7.75% 6%
Foreign Currency Swaps (cont)
1. Each party borrows in their domestic currency where
each enjoys a comparative advantage (Note: US Co
would pay less in both markets but it enjoys a
comparative advantage in the US market of 1%).
2. The two parties exchange principal amounts at the
prevailing spot rate.
3. Both parties make interest payments to each other at
the rate at which they could have borrowed in the
foreign market.
4. At the conclusion of the swap both parties re-
exchange principals at the original exchange rate.
Steps in Constructing a Cross Currency Swap

US Co can borrow at lower rate for both fixed and floating hence
US Co has Absolute Advantage in borrowing
Aus Co US Co Difference in rates
In Australia 8.0% 7.75 % 8.0 – 7.75 =0.25%
In US 7.0% 6% 7.00 - 6.0 = 1.00%

US Co will save 1% borrowing in the US and save only 0.25% borrowing in Australia
US Co has comparative advantage in borrowing in US,
Hence, US Co will borrow in US while AUS Co will then borrow in Australia
Steps in Constructing a Cross Currency Swap

Net Difference between borrowing in US and Australia (savings) 1.00 – 0.25 =

0.75%
Aus Co. US Co Intermediary
Bank
Bank requires 0.25%
0.25%
0.75-0.25 =0.5, 0.25% 0.25%
Share 0.5 equally

Outcome of Swap Borrows in Australia at 8% Borrows in the US at 6% Intermediary

Goes into a swap and Goes into a swap and bank earns
Pays intermediary Pays intermediary 0.25%
7.0 -0.25 = 6.75% 7.75 - 0.25= 7.50%

By going into a SWAP,

Aus Co saves 0.25% in USD cost of borrowing,
US Co saves 0.25% in AUD cost of borrowing
and intermediary bank gains 0.25% for bearing risk
Foreign Currency Swaps (cont)
Aus Co pays USD 6.75 % US Co receives USD 6%
to bank, saves 0.25% From Bank

Bank Makes 0.75%

Aus from USD flow US
Co. Co.
AUS co receives
Bank loses 0.50% US Co pays AUD 7.5%
AUD 8.0% from bank From AUD flow to bank,
Saves 0.25%
Bank makes 0.25%

Interest payments Interest payments

at A$25m x 8.0% at US$20m x 6%

Borrow Borrow
AUD25mil in USD20mil in
Aus at 8% US at 6%

CA in Australia CA in US
 Currency Swap Strategies
 To achieve a lower borrowing cost
 a firm might get a better rate in its home currency due to
its familiarity to lenders but actually wants to borrow in a
foreign currency so may use a currency swap to achieve
cost lower than borrowing directly in the foreign currency
 the ‘comparative advantage argument is not so strong
now and currency swaps have become an instrument
offered by banks to clients seeking to achieve objectives
other than lower loan costs.
 It’s also possible at times for a firm with a high credit
rating to get a better rate in a foreign country and then
swap into local currency to achieve a lower cost.
Currency Swaps Strategies (cont)
 Currency swaps can also be used for hedging foreign
exchange risk. For example:
i. Borrow in local currency and then swap the loan into a
FC in which the company has an existing revenue
exposure for example
ii. Convert an existing FC loan into local currency prior to
its maturity to lock in an unrealised Foreign Currency
gain on the loan arising from a favourable FX
movement.
 Currency Swaps can be used for hedging exposures
much like currency forwards and futures but usually a
longer time frame is involved.
Main Differences between an Interest Rate Swap and a

Cross Currency Swap

IRS Xccy Swap

Trade date Agree on a notional amount Exchange of principal
No exchange of principal
Currency Single currency Two different currencies
Life of the Net exchange of difference Full exchange of cash flows
swap between set rates at each at each payment cycle . i.e.
payment cycle No Netting
Maturity IRS expires Principal is returned to
counterparty
“A ship is safe in harbor,

but that's not what ships are for.”

― William G.T. Shedd

- And that is why we learn risk management