Swaps

NICHOLAUS, Masawe
Definition
A swap is an agreement between two parties to exchange cash flows
related to specific underlying obligations or benefits for an agreed
period of time
Illustration
A Ltd (US MNC) wants to finance a € 40m expansion of a French Plant.
On the other side, B ltd which is a French company wishes to finance
operations in USA at $ 52m .
You are also given the following rates

$ €
A Ltd 8% 7%
B Ltd 9% 6%

Required
Show how currency swaps could be used
Types of Swaps
1. Interest rate Swaps
2. Currency swaps
Interest Rate Swaps
NICHOLAUS, Masawe
Definition
An interest rate Swap is a contractual obligation between two counter
parties to exchange interest obligations or benefits
Both interest payments or benefits are calculated on the basis of a
notional principal that is never exchanged
Plain vanilla Interest rate Swap
This is an agreement between two parties to exchange interest
payments on a notional amount of principal at regular interest
payment dates throughout the life of swap
One party pays interest at a fixed rate and the other pays interest at a
variable or floating rate which is usually the LIBOR.
The fixed and variable rates are denominated in the same currency
In practice, a compensatory amount or payment is made by one
counter party to the other depending on whether the floating rate
turns out to be higher or lower than the fixed rate
What drives Interest rates Swaps
From Fixed to Floating
If the borrower anticipates fall in interest rate, it would wish to pay
interest in floating

From floating to fixed

If a borrower anticipates increase in interest rates, it would wish to pay
interest at fixed rate
Illustration I
A company has a loan of £ 5m on which it pays Libor + 1%.
The loan has a remaining term of 4 years. The company is concerned that
interest rate are likely to rise and it wants to fix its debt payment
obligations.
A bank specializing in Swaps will agree to a 4 years in which it receives
5.5% in exchange for paying the LIBOR every six months

Required
Calculate the rate at which the overall company’s borrowing cost will be
fixed by the bank through the Swap arrangement
Illustration II
A company has a £ 20m loan of 7% bonds in issue which have a remaining maturity
of 10 years. Interest is payable every six months.

The company thinks that interest rate will fall and would like to swap its fixed
interest rate obligations for floating rate obligations.

A bank specializing in Swaps is willing to arrange a 10 years swap on £ 20m in

which it pays a fixed rate of 6.15% and receives 6 months LIBOR with interest
payment exchanged every six months
Required
Calculate the net cost of borrowing to the company under the swap arrangement
Illustration III
A company has a bank loan of $30 million on which it
pays variable rate interest at dollar LIBOR + 1%. The loan
has five more years to maturity.
The company is worried about the risk that interest rates
will soon rise, and it wants to set a limit on its interest
costs.
The bank might quote rates of 5.34 – 5.39 for a five-year
swap in sterling.
Required
By arranging a swap, what will be the effective interest
cost for the company?
Illustration IV
A company has 5% bonds in issue with a nominal value of 40 million
euros.

The bonds have ten more years to maturity. The company wants to
exchange its fixed rate liability for a floating rate liability in euros.

A bank quotes the following rate for a ten-year swap: 4.22 – 4.25.
Required
By arranging a swap, what will be the effective interest cost for the
company?
Illustration V | Credit arbitrage
 Cat plc and Dog plc, both want to borrow £150m for eight years
 Cat would like to borrow on a fixed-rate basis
 Dog prefers to borrow at floating rates

Fixed Floating
Cat can borrow at 10% LIBOR +2%
Dog can borrow at 8% LIBOR +1%

Required
By arranging a swap, what will be the effective interest cost for the
company?
.
Currency Swaps
NICHOLAUS, Masawe
Introduction
Unlike an interest Rate Swap, Currency swaps involves dealing with
two currencies
The principal amounts are usually exchanged at the origination and
maturity dates of the contract
Currency swaps is most often used when companies make cross
border capital investments
What drives currency swaps
Reduction in financing charges is the main motive
Example
Assume that a Tanzanian Company wants to finance a project
undertaken by its subsidiary in Kenya. Project proceeds would be used
to pay interest and principal

Required:
Show possible financing options
Possible Options
1. Borrow in TZS and convert to KES-
By doing this the company is exposed to exchange rate risk
2. Borrow in Kenya-
Borrowing in Kenya may be at high rate as compared to what would have been
charged in TZ because the subsidiary is relatively unknown in Kenya
3. Find a counterparty and set up a currency swap
Illustration
A Ltd (US MNC) wants to finance a € 40m expansion of a French Plant.
On the other side, B ltd which is a French company wishes to finance
operations in USA at $ 52m .
You are also given the following rates

Required
Show how currency swaps could be used
Illustration
A Ltd (US MNC) wants to finance a € 40m expansion of a French Plant.
On the other side, B ltd which is a French company wishes to finance
operations in USA at $ 52m .
You are also given the following rates

$ €
A Ltd 8% 7%
B Ltd 9% 6%

Required
Show how currency swaps could be used
Steps involved in Currency Swaps
1. At the commencement of the Swap, the counterparts exchange
principal amounts
2. At interest payments dates, the counter parts exchange interest
denominated in each other’s country currency and rates
3. At maturity, of the contract, , the principal amount are re exchanged
Benefits of Currency Swaps
1. Access to capital markets that the company is unable to approach
directly
2. Helps to reduce finance costs
3. Low transaction costs
Illustration : NBAA Nov 2005
Two counter parties agree to enter into a foreign currency swap
between American dollars and Swiss franks. One dollar is currently
worth 1.4 Swiss Franks
The American dollar payer will provide $ 500,000. The interest rate on
the dollar is 9% and the Swiss frank rate is 8%
The Swap calls for a life of three years with annual payments
Required
a) How much will the provider of the dollar pay at the outset?
b) If the interest rate do not change, what is the annual dollar interest
payment for the foreign borrower of dollars
c) If the net payment is recorded for the interest in year one, and
exchange rates do not change , what will be the net payment
d) What will be the total payment in Swiss Franks by the borrower of
USA dollars for year 3
e) What will be the total payment in the USA dollars by the borrowers of
Swiss Franks for year 3