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.