SWAPS The Short-Term Currency Swap An illustration: Bank of England (BoE) wants to borrow USD from...

SWAPS• The Short-Term Currency Swap

An illustration:

Bank of England (BoE) wants to borrow USD from the Bundesbank (Buba). Buba asks, as security, an equivalent amount of GBP (to be deposited by the BoE with the Buba). Barring default, on the expiration day the USD and the GBP would each be returned, with interest, to the respective owners

Example

S = USD/GBP 2.5, r$ = 3%, r£ = 5%.

time t: BoE receives USD 100m from the Buba for six months, deposits GBP 100m/2.5 = GBP 40m into an escrow account with the Buba.

time T: the Buba returns GBP 40m ¥ 1.05 = 42m, and the BoE returns USD 100m ¥ 1.03 = USD 103m

SWAPS• Two ways to view the traditional short-time swap

contract

View 1: two mutual loan contracts, one for USD 100m to the Bank of England, and the other for GBP 40m to the Bundesbank, with a right-of-offset clause linking the two loans.

“if one party fails to fulfill its obligations, then the other party is exonerated from its normal obligations too, and can sue the defaulting party if any losses occur”

The Short-Term Currency Swap

USD loan [BB—>BE] GBP loan [BB—>BE]

At time t: BB transfers USD 100m BE transfers GBP 40m spot sale ofto BE to BB USD 100m to BE

at St = USD/GBP 2.5

At time T: BE transfers USD 103m BB transfers GBP 42m forward purchase ofto BB to BE USD 103m from BE

at Ft,T = 2.39535

Total: swap contract

SWAPS

• Two ways to view the traditional short-time swap contract

View 2: a spot sale by the Bundesbank of USD 100m for GBP, combined with a six month forward purchase of USD 103m at

103/42 = 2.45238 = USD/GBP 2.5 ¥ 1.03/1.05 = F.

SWAPS

• Why short-term Swaps exist?

1. Safety

2. Reduction of Transaction Costs

3. Tax Avoidance

4. Religious objections against interest

5. Fictitious Transactions

SWAPS

• Why short-term Swaps exist? (cont.)

1. Safety:

ExampleRepurchase order (repo): an investor in need of short-term financing sells low-risk assets (like T-bills) to a lender, and buys them back under a short-term forward contract

Low-risk loan fi low bid-ask spread ('haircut')

SWAPS


2. Reduction of transaction costs:

If an investor intends to reverse the transaction

Example

A French investor is optimistic about $ returns on US stocks, but not about the $ itself. She buys spot USD to invest in US stocks, and sells USD forward to hedge the $ risk

SWAPS


3. Tax Avoidance:

When capital gains are taxed at a lower rate

ExampleBuy 10 kilos of gold from a bank at the spot price St = LUF

5m and sell it back (forward) at Ft,T = St (1+rt,T) = 5.25m

This is a disguised deposit of LUF 5m at 5%, but the return isa capital gain

SWAPS


4. Religious objections against interest: Catholic Church, Islam

5. Fictitious transactions: • Hide losses by selling assets at inflated prices (and buy them

back at similarly inflated forward prices)

• Hide the ownership of assets by conjuring them away around the reporting date

SWAPS

• Back-to-Back and Parallel Loans

The right-of-offset was already used in back-to-back and parallel loans

Back-to-back loans:UK institutional investor (UKII) wants to invest in US. But “investmentdollar premium” made foreign investments expensive to UK investors. Thus, UKII wants to avoid the spot market at t and T, by setting up a deal with a foreign firm (USCo) that wants to invest in the UK:

• USCo lends USD to UKII• UKII lends GBP to USCo (or its UK subsidiary)

Right of offset between these two loan contracts: if (say) UKII cannot pay back, USCo can withhold its payments and sue for the net loss (if any)

SWAPS

Back-to-back loans: (cont.)

USCo's SUBSUKII

USCoUSD cap mkt

USD

GBPUSCo's SUBSUKII

USCoUSD cap mkt

USD

GBP

Flow of initial principals under a back-to-back loan

SWAPSParallel loans:

• USCo faces capital export controls, cannot export USD to itsUK subsidiary

• UKCo wants to lend to its US subsidiary, but there is adollar premium

• Both can avoid the spot market by granting loans to each other (or to each other’s subsidiary), with a right of offset in the two loan contracts

USCo's SUBSUKCo

USCo UKCo's SUBS USD

GBP

The initial flows of principal under a parallel loan

SWAPS• The 1981 IBM/World Bank Currency Swap:

IBM wanted to call its DEM- and CHF debt: the USD had

appreciated considerably and the DEM and CHF interest

rates had also gone up. But this would be costly:

• Exchange transaction costs when IBM buys DEM and CHF

• Call premium: IBM has to pay more than the DEM and

CHF face value

• Issuing costs when IBM issues new USD bonds.

• Capital gains taxes on realized gain

SWAPS• The 1981 IBM/World Bank Currency Swap:(cont.)

The World Bank (WB) wanted to borrow DEM and CHF to lend

to its own customers

• issuing costs on new CHF and DEM bonds

Note that IBM wants to withdraw CHF and DEM bonds (at a rather high cost) while WB wants to issue CHF and DEM bonds (also at a cost). To avoid most of these costs, IBM and WB agreed that WB would take over IBM’s foreign debt instead


Specifically,

• WB borrows USD instead of DEM, CHF. With the proceeds it buys

spot CHF and DEM for its loans

• WB undertakes to deliver to IBM the DEM and CHF necessary

to service IBM’s old DEM and CHF loans,

... while IBM promised to provide the WB with the USD needed

to service the WB's (new) USD loan;


Right of offset between the undertakings

DEM & CHFbondholders

USD Eurobondholders

IBM WB

USD service

DEM & CHF service

USDDEM & CHF

Equal initial value principle: the present value of IBM's (USD) payments to the WB is equal to the present value of the (DEM and CHF) inflows received from the WB.


Example

• IBM’s DEM debt is DEM 10m at 5% maturing within 5 years

• The current 5-year DEM interest rate is 10% and

St = USD/DEM 0.4

• Market value of service payments:

(1) DEM 10m ¥ [1 + (.05 - .1) ¥ a(10 %, 5 years)]

= DEM 8.105m

or 8.105 ¥ .4 = USD 3.242m. So the USD loan should also be

worth USD 3.242m.

SWAPS• The Fixed-for-Fixed Currency Swap

First review the short-term swap:

the contract has zero initial value

• The spot and forward contracts each have zero value because

the amounts are exchanged at the going spot and forward rate

• Also in the “mutual loan” view, zero initial value holds

[example (Buba/BoE): 5% on GBP, 3% on USD, St=2.5]:

PVUSD = = USD 100 ; and

PVGBP = = GBP 40, or USD 100

SWAPS• The Fixed-for-Fixed Currency Swap (cont.)

the rates used for setting the forward rate or, equivalently,

for discounting the promised payments are the (near-riskless)

short-term interbank rates:

• default risk is limited by the forward contract’s right-of-offset

• remaining risks are largely eliminated by screening of

the customers, and by margins or other pledges

SWAPSCharacteristics of the Modern Currency Swap

Definition. Two parties agree to:

• exchange, at time t, two initially equivalent principals

denominated in different currencies

• return these principals to each other at T

• pay the normal interest, periodically, to each other on the

amounts borrowed

SWAPSCharacteristics of the Modern Currency Swap (cont.)

The deal is structured as one single contract, with a right of offset

Example

Leg 1 (DEM) leg 2 (USD)18m at 8% 10m at 7%(“lent”) (“borrowed”)

Initial exchange of principals <DEM 18.0m> USD 10.0mannual interest payments DEM 1.44m <USD 0.7m>payment of principal at T DEM 18.0m <USD10.0m>


Swap rates The interest payments for each currency are based

on the currency's "swap (interest) rate"—yields at par for

near-riskless bonds with the same maturity as the swap

Why riskfree rates?

right-of-offset clause; sometimes margin is posted probability

f default is small: screening, 'credit trigger' the uncertainty

about the bank’s inflows is the same as the uncertainty

about the bank’s outflow side. Thus, the corrections for

(minute) risk virtually cancel out


Zero Initial value The initial exchange of principals is a

zero-value transaction because the amounts are initially

equivalent. The future interest payments and amortization

have equal present values, too

Example

(2) PVUSD = + = USD 10m,

(3) PVDEM = + = DEM 18m

which implies that the PV in USD is 18m/1.8 = USD 10m


Costs A commission of, say, USD 500 on a USD 1m swap,

for each payment to be made. Most often this fee is built into

the interest rates, which would raise or lower the quoted rate

by a few basis points

Sometimes an equivalent up-front fee is asked

Example7-year yields at par are 7.17% on USD and 9.9% on DEM. The swap dealer quotes:

USD 7.13% - 7.21%DEM 9.58% - 9.95%

If your swap contract is one where you "borrow" DEM and

"lend" USD, you pay 9.95% on the DEM, and you receive

7.13% on the USD

SWAPS•Coupon Swaps (Fixed-for-Floating)

Characteristics of the Fixed-for-Floating Swap

Example

An AA Irish company wants to borrow NZD to finance (and

partially hedge) its direct investment in New Zealand.

Better conditions in London than in Wellington preference

for fixed-rate loans, but spread on revolving bank loans is

lower than spread on fixed-rate Eurobonds:

[LIBOR+1%] vs 19% [= swap rate + 3%]

SWAPS•Coupon Swaps (Fixed-for-Floating)

Characteristics of the Fixed-for-Floating Swap (cont.)

The company borrows NZD at the (risk-free) swap rate (16%)

plus the spread of 1% it can obtain in the "best" market (the

floating-rate Eurobank-loan market)

loan total1m at 1m at LIBOR 1m at 16% loan + swap

LIBOR + 1% ("lent") ("borrowed")

t: principals 1 <1> 1 1

interest <LIBOR + 1%> LIBOR 16% <16% + 1%>

T: principal <1> 1 <1> <1>

swap contract

SWAPS

• Base Swaps

Example: IN: T-bill rate / OUT: Eurodollar (LIBOR)

Why?

• To speculate on the TED spread

• (For a swap dealer): to hedge two (unrelated) coupon

swaps—one where IN is LIBOR and OUT is T-bill

SWAPS

• Cross-Currency Swaps

Renault

operating income

Yamaichi Securities

floating rate note portfolio

YEN fixed

YEN fixed

USD floating

YEN fixed

USD floating

Renault's USD floating rate note holders

Bankers Trust

Yamaichi's Yen fixed rate lenders

USD floating

SWAPS

• Cocktail Swap

USD fixed- rate lenders

USD 12% USD 12%

CHF 5%

CHF 5% fixed

USDLIBOR + .75%

USD 12% fixed

USDLIB +.75%

Co A

Bank B

Co CCo D

USD floating- rate lenders

CHF fixed- rate lenders

SWAPS• Conclusions

Swaps allow a company to • borrow in the market where it can obtain the lowest

spread

exchange the risk-free component of the loan’s service • payments for the risk free component of a another loan

that is thought to be more suitablemost suitable loan: fixed rate floating rate

fixed rate:in the same currency: - interest rate swap

in another currency: fixed-for-fixed circus swapcurrency swap

floating-rate:in the same currency: interest rate swap -

in another currency: circus swap floating-for-floatingcurrency swap

original loan (with the lowest spread)

SWAPS• Case. An Interest Rate Swap: Will it work?

Basket Corporation Metro Bank Sushi Bank

Fixed Rate Payer

12% Fixed

Floating Rate Swap

LIBID (-)1/8%Target Rates

At least 12 basis points

Fixed Reference Rate:

- 7 year note

- All in cost 127/8%

= 12.875%

Floating Reference Rate:

- Commercial

- Paper rate + 1/2% fee

93/8 + 1/2% = 97/8%

Basket

Basket

Sushi Bank can issue 7-yr

Eurobond at 12%

SWAPS• Case. An Interest Rate Swap: Will it work? (cont.)

LIBOR (overnight) = 9%

Basis Swap 7 days = 91/8%

1 month = 92/8%

3 months = 93/8%

6 months = 95/8%

1 year = 97/8%

Total Gain/Loss: + 109.5 basis points

- 50.0 basis points

for basket + 59.5 basis points

CP + 1/4%

Vs.

LIBOR


From Sushi Bank:

Point of View:

Sushi receives reference: 11.66% ie 112/3%

12%

Sushi pays: LIBOR - 1/2%

Reference: LIBOR - 1/8%

Total Gain to Sushi Bank: 1/3 - 1/8% = 1/12%

3/8 - 1/3 = (9-8)/24 = 1/24%

1/3% loss

(-) 3/8% gain


Gain to Metro Bank: 12 basis points

1. Swap is successful

2. Default Risk of Counter Parties

SWAPS The Short-Term Currency Swap An illustration: Bank of England (BoE) wants to borrow USD from...

Documents

Transcript of SWAPS The Short-Term Currency Swap An illustration: Bank of England (BoE) wants to borrow USD from...