Swaps: Interest Rate and Currency Swaps

Interest Rate and Currency Swaps

  • Two main types of swaps:
    • Interest rate swaps.
    • Currency swaps (also known as cross-currency interest rate swaps).
  • Swaps originated due to interest rate volatility and the need for hedging interest rate risk for both investors and borrowers.
  • Early use of swaps involved businesses with cash trapped in a country, using arrangements like parallel loans.
    • Example: A business with money stuck in Argentina could lend to another business needing money there, which in turn would lend money in the US.

Swap Participants and Contracts

  • Participants in a swap are referred to as counterparties.
  • They enter side contracts with a notional value based on the transaction size.
  • Swaps involve agreements to exchange cash flows periodically.

Types of Swaps

  • Single Currency Interest Rate Swaps: Both parties use the same currency.
  • Cross Currency Swaps: Involve different currencies.
    • Example: AT&T issuing debt in British pounds with a swap contract to provide the pounds in exchange for dollars.
    • Facilitates issuing debt in multiple currencies, even without generating that currency naturally.

Development of Swaps

  • Currency swaps developed first, potentially from situations involving trapped cash.
  • Interest rate swaps came later.
  • Swap size is measured by notional principal, which determines cash flows.
  • In interest rate swaps, the principal is usually not exchanged.
  • The notional principal is associated with an underlying debt obligation or investment.

Market Size and Intermediation

  • In 2018, the market size was significant: Interest rate swaps at 326 trillion and currency swaps at 24 trillion.
  • Top currencies involved: US dollar, Euro, Yen, British pound sterling, and Canadian dollar.
  • Financial intermediation is necessary for swaps to occur efficiently.
    • Banks act as intermediaries between parties, facilitating swaps.
    • Banks make money through this intermediation.

Swap Brokers vs. Swap Dealers

  • Swap Broker: Matches payer and receiver but does not assume the risk of the swap.
  • Swap Dealer: Stands as a counterparty and deals as a principle, assuming risk.
  • Swap dealers can include international banks, commercial banks, investment banks, or independent operators.

Customization and Creditworthiness

  • Swaps are traded over-the-counter (OTC) and can be tailored to customer needs.
  • Dealers provide market quotations for plain vanilla swaps.
  • Counterparties are typically strong credits (AA or AAA), but it's not limited to these.
  • There is credit risk: If a counterparty fails, the swap bank may incur costs to replace them.
  • Collateral and mark-to-market systems are used to manage credit risk.
  • Swaps typically do not involve below-investment-grade entities.

Interest Rate Swap Quotations

  • Interest rate swap rates are quoted against a local standard reference in the same currency.
  • Currency swap rates are quoted against the dollar.

LIBOR Replacement

  • LIBOR (London Interbank Offered Rate) is no longer used; it was discontinued due to a scandal.
    • Banks were found to be manipulating LIBOR to benefit their positions.
  • The replacement index is SOFR (Secured Overnight Funding Rate) in the US.
  • The Euro equivalent is ESTER.

Swap Bank Quotes

  • If a swap bank quotes against a fixed rate of Swiss franc against Swiss franc floating, it's an interest rate swap.
  • If quoted against Dollar Libor, it is a currency swap.
  • The quote indicates the rate the bank will pay (e.g., 6.6%) and the rate they will charge (e.g., 6.7%).
  • The bank always makes money on the spread.
  • Borrowers concerned about rising interest rates will want to pay a fixed rate.
  • Those expecting rates to fall may want to pay a floating rate.
  • The bank's profit is the difference between these rates, e.g., 10 basis points.

Example: Bank A and Company B

  • Bank A (AAA-rated):
    • Needs 10 million USD funding to finance floating-rate euro dollar term loans.
    • Can issue 5-year floating rate notes indexed to Libor or 5-year fixed-rate euro dollar bonds at 10%.
    • Floating rate notes make more sense for the bank to be match-funded.
  • Company B (Triple-B rated):
    • Needs 10 million to finance a capital expenditure with a 5-year economic life.
    • Prefers a fixed rate to stabilize the cost of funds.
    • Can issue 5-year fixed-rate bonds at 11.25% or 5-year floating rate notes based on Libor plus 50 basis points.
    • Fixed-rate debt makes more sense for Company B.
  • A swap bank can set up a fixed-for-floating interest rate swap to benefit each counterparty.

Swap Bank Quotes and Quality Spread Differential

  • The swap bank quotes 5-year U.S. dollar interest rate swaps at 10.375% (they pay) and 10.5% (you pay them) against Libor flat.
  • The quality spread differential is necessary for the swap to work.
  • It makes it possible for each counterparty to issue the debt alternative that is least advantageous and then swap interest payments, resulting in a lower all-in cost.
  • This is a form of comparative advantage.

Comparative Advantage in Swaps

  • If a company can borrow at a fixed rate more competitively than at a floating rate, they should borrow fixed and swap to floating.
  • Similar to comparative advantage in international trade.
  • Company B borrows at a fixed rate at 11.25%, Bank A at 10%. Differential is 1.25%.
  • On a floating rate, Company B pays Libor plus 50 basis points, Bank A pays Libor. Differential is 50 basis points.
  • Quality spread differential is 75 basis points.

Swap Mechanics and Benefits

  • Bank A can issue euro dollar bonds at a fixed rate of 10%.
  • By going to the swap bank, they can receive 10.375% on a fixed rate.
  • This enables them to borrow at a fixed rate at 10% and receive the 10.375%.
  • They pay Libor to the bank, achieving a floating rate payment even though they raised fixed rate bonds.
  • Bank A pays Libor to the swap bank and 10% on fixed rate debt but receives 10.375% from the bank.
  • Their all-in cost is Libor + 10% - 10.375% = Libor - 0.375%.
  • Company B can borrow fixed at 11.25% or floating at Libor + 50 basis points.
  • If they borrow at a floating rate and swap, they pay the bank 10.5% on a fixed rate and receive Libor.
  • Since it costs them 50 basis points to raise floating rate debt over the index, they're receiving the index.
  • Their costs and what they receive and pay is 10.5% + Libor + 50 basis points - Libor = 11% versus 11.25%.
  • Their saving is 25 basis points.

Currency Swaps

  • Involve different currencies.
  • Example: US multinational desires to finance a capital expenditure of its German subsidiary.
    • Project cost: €40 million.
    • Exchange rate: 1.30 USD/EUR.
    • Parent could raise 52 million USD by issuing five-year bonds at 8%.
    • Convert dollars to euros to pay the project cost.
    • The German subsidiary would be expected to earn enough to meet annual dollar debt service and repay the principal in five years.
    • Creates long-term transaction exposure.

Alternative Financing and Currency Exposure

  • US parent could raise euros.
    • Issue euro-denominated debt ( €40 million).
    • Currency risk shifts to US parent.
  • If they are not well known, they will have difficulty borrowing at the best interest rate.
  • Could borrow euros at a fixed rate of 7%.
  • A better-known European company would only pay 6%.

Example: German Company with US Subsidiary

  • A German company has a US subsidiary that needs 52 million USD for a five-year capital expenditure.
  • They could raise €40 million and pay only 6% because they are a well-known German company.
  • They would convert the funds to dollars.
  • They too would have transaction exposure.
  • The German parent could issue euro dollar bonds (dollar-denominated bonds outside the US).
  • Since not well-known, borrowing costs would be 9%.

Swap Bank and Comparative Advantage

  • The swap bank gets in the middle and creates a currency swap.
  • Each parent firm raises funds in their national capital markets where they have a comparative advantage.

Quality Spread Differential in Currency Swaps

  • US company: dollar financing cost at 8%, German multinational at 9%. Difference is -1%.
  • To raise EUR, the US pays 7%, the German pays 6%. Difference is -1%.
  • Quality spread differential: -1 - (-1) = -2%.

Currency Swap Mechanics

  • The US multinational can raise EUR at 7%.
  • Instead, they raise dollars at 8%.
  • They pay the swap bank 6%, and the swap bank pays them 8%.
  • They are effectively paying 6% instead of 7% by swapping.
  • The German multinational raises money at 6%.
  • They pay the swap bank 8%. They are receiving 6% so that they could pay the bondholders, and otherwise, they would have just gone out and borrowed dollars.

Variations of Swaps

  • Fixed for floating interest rate swaps.
  • Zero coupon swaps.
  • Floating for floating (floating euro against floating dollars).
  • Amortizing swaps.

Risks of Swaps

  • Interest Rate Risk: Risk of interest rates changing unfavorably before the swap bank can find an opposing counterparty.
  • Basis Risk: Floating rates of the two counterparties are not pegged to the same index.
  • Exchange Rate Risk: The swap bank faces risks from fluctuating exchange rates during the time it takes to lay off the swap.
  • Credit Risk: The probability that a counterparty or even the swap bank will default.
    • Lehman Brothers defaulted on an interest rate swap in 2008.
  • Mismatch Risk: Difficulty finding the exact opposite match.
  • Sovereign Risk: Countries could impose restrictions (capital controls).

Efficiency and Reasons for Using Swaps

  • Obtain debt financing in the swapped currency at a better interest cost.
  • Benefit of hedging long-run exchange rate exposure.
  • Better match for maturity of assets and liabilities and obtain cost savings.
  • Market completeness.
  • Tailoring financing.

Standardization

  • There is a standardization through International Swap Dealers Association.
  • There's a master agreement, and nobody touches the master agreement. They have a schedule that does some definitions.
  • That enables it to be as tradable as consistent as possible.