Multinational Business Finance: Interest Rate Risk and Swaps

Multinational Business Finance – Chapter 8: Interest Rate Risk and Swaps

Learning Objectives

  • 8.1 Explain interest rate foundations, including interest rate calculations and reference rates.

  • 8.2 Define the cost of debt for both governments (sovereign borrowers) and corporate borrowers.

  • 8.3 Analyze interest rate risk and examine a variety of methods for its management.

  • 8.4 Explore the use of interest rate futures and forward rate agreements in managing interest rate risk.

  • 8.5 Examine the use of interest rate swaps to manage the interest rate risks of multinational firms.

Interest Rate Foundations (1 of 3)

  • International Interest Rate Calculations

    • Importance: Key concern for any firm borrowing or investing globally.

    • Example in Exhibit 8.1: Demonstrates three calculation methodologies that yield different 1-month interest payments on a $10 million loan at a 5.500% per annum rate over 28 days.

Interest Rate Foundations (2 of 3)

  • Reference Rate:

    • Definition: The interest rate used in standardized loan agreements or financial derivatives valuation.

    • LIBOR: The London Interbank Offered Rate is the most widely referenced interest rate globally.

Interest Rate Foundations (3 of 3)

  • Exhibit 8.2:

    • Displays the 3-month USD LIBOR over the past 30 years.

    • Key observations: LIBOR rose to over 10% in the late 1980s and dropped to nearly 0% after 2008.

  • Exhibit 8.3:

    • Compares 3-month LIBOR rates for five major currencies from January 1999 to June 2021, showing wide variations.

The Cost of Debt

  • Components:

    • Cost of Debt Formula: Risk-free rate of interest + Credit risk premium.

    • Credit Risk Premium: Typically dependent on the borrower's credit rating.

    • U.S. Treasury Yield Curve: Establishes base rates for corporate credit pricing.

  • Exhibit 8.4: Compares credit ratings and associated cost of funds as of October 28, 2014 (5-year maturities).

  • Exhibit 8.5: Shows how the cost of debt changes with maturity.

Credit Risk and Repricing Risk

  • Credit Risk (Roll-over Risk): Possibility of a borrower's creditworthiness being re-evaluated by a lender upon renewal.

  • Repricing Risk: Risk of changes in interest rates at the point of financial contract's rate reset.

Sovereign Debt and Spreads

  • Government (Sovereign) Debt:

    • Generally regarded as low risk; governments can service debt denominated in their own currency.

    • Emerging market governments often raise capital in international markets.

  • Exhibit 8.6: Compares costs paid by various sovereign borrowers over U.S. Treasury rates (USD sovereign spread).

European Sovereign Debt

  • EU Member Constraints: Cannot print more euros but can set fiscal policies, affecting debt servicing costs due to varying credit qualities.

  • Post-global financial crisis (2008-2009), many EU governments had difficulty managing their sovereign debt, resulting in higher borrowing costs.

  • Exhibit 8.7: Analyzes sovereign spreads for various EU countries post-crisis.

Interest Rate Risk

  • Risks for Non-Financial Firms: Includes debt service obligations and holdings of interest-sensitive securities.

  • Competitive pressures require more stringent management of interest rates affecting both sides of a firm's balance sheet.

Floating-Rate Loans (1 of 2)

  • Use of Floating-Rate Loans:

    • Common global financing tool; however, it carries significant interest rate exposure.

  • Exhibit 8.8: Illustrates costs and cash flows for MedStat, which has a 3-year floating rate loan; despite a floating LIBOR component, MedStat effectively pays a fixed spread of 1.250%.

Floating-Rate Loans (2 of 2)

  • Options to Manage Interest Rate Risk:

    • Refinancing

    • Interest Rate Futures

    • Forward Rate Agreements (FRA)

    • Interest Rate Swaps

Interest Rate Futures and Forward Rate Agreements (1 of 2)

  • Attractiveness of Interest Rate Futures:

    • High liquidity, simplicity, and standardization.

  • Exhibit 8.9: Analysis on yields and prices for Eurodollar futures, highlighting market variations.

Interest Rate Futures and Forward Rate Agreements (2 of 2)

  • Speculative Positions in Futures: Firms may also purchase interest rate futures for speculative purposes.

  • Exhibit 8.10: Overview of strategies pertaining to common interest rate exposure management with specific actions and outcomes listed.

Forward Rate Agreements

  • Definition:

    • An interbank-traded contract to buy/sell interest rate payments on a notional principal.

    • Allows locking in an interest rate for a term starting at a future date, with maturities spanning 1, 3, 6, 9, and 12 months.

Interest Rate Swaps

  • Swaps Overview: Agreements to exchange cash flows; types include:

    • Interest Rate Swap: Exchanging fixed interest rate payments for floating payments.

    • Currency Swap: Involves degree exchange of debt service currencies.

    • Potential to blend aspects of both swap types: hybrid swaps.

  • Firms enter swaps for various reasons and can manage notional principals differing from the total position.

Illustrative Case: MedStat’s Floating-Rate Debt (1 of 2)

  • Recent LIBOR Trends: Upward shift in LIBOR rates.

  • MedStat's management considers a pay-fixed, receive-floating swap:

    • Floating Component: Loror

    • Fixed Component: 3.850% swap rate.

Illustrative Case: MedStat’s Floating-Rate Debt (2 of 2)

  • MedStat's floating rate payment structure explained:

    • Receives LIBOR floating payments and pays a fixed rate which consists of the fixed spread and the swap rate.

Alternative Futures

  • Exhibit 8.12: Analysis of a scenario where MedStat's options worsen due to rising LIBOR rates, with higher rates available impacting management options.

Plain-Vanilla Swap Strategies

  • Companies with high credit ratings utilize swaps to adjust their exposures without incurring direct market fees.

  • Companies with lower credit quality might use swaps to shift from paying floating to fixed rates.

Cross-Currency Swaps

  • Exhibit 8.13: Details typical swap rates across various currencies without dependency on credit ratings.

  • Rationale for currency swaps typically involves shifting undesired cash flows into more favorable currencies.

MedStat Uses a Cross-Currency Swap

  • Two key differences from standard swaps:

    • The establishment of notional principal via the spot rate at agreement initiation.

    • Accounting implications of gains/losses persisting through the swap's duration.

MedStat Unwinds a Currency Swap

  • Unwinding Process: Involves discounting remaining cash flows at current interest rates, followed by conversion back into the firm's home currency.

Counterparty Risk

  • Definition: Refers to the risk that the counterpart in a financial agreement might fail to meet its obligations.

  • Despite growth in derivatives markets, default rates remain low.

Appendices

Appendix 1: Interest Payment Methods

  • Details three methods to derive interest payments on a $10 million loan at 5.500%.

  • International calculation yields a payment of $42,777.78; British yields $42,191.78, and Swiss/Eurobond results in $45,833.33.

Appendix 2: U.S. Dollar 3-Month LIBOR

  • Historical trends with key events influencing rate fluctuations.

  • LIBOR peaked near 10.2% in 1988, reflecting economic downturns and recovery periods following.

Appendix 3: LIBOR Curves for Multiple Currencies

  • Comparisons of LIBOR rates for USD, Euro, GBP, CHF, and JPY, mapping their similarities in peak and decline trends but differing timings.

Appendix 4: Credit Ratings and Cost of Funds

  • In-depth details on investment-grade ratings and their historical average rates/spreads.

Appendix 5: Credit Spreads Across Ratings

  • Analysis of credit spread differences, especially for speculative-grade borrowers.

Appendix 6: Sovereign Spreads Over U.S. Treasuries

  • Trends comparing the basis point spreads of countries like Brazil, Russia, and Pakistan.

Appendix 7: Selected EU Sovereign Spreads

  • Examination of divergences in debt servicing capability post-2008 crisis among EU members.

Appendix 8: MedStat's Loan Analysis

  • Evaluation of cash flows and interest payment structure from MedStat's floating rate loan.

Appendix 9: MedStat's Interest Rate Swap Considerations

  • Observational graphs depicting LIBOR and spread impacts.

Appendix 10: Deteriorating Choices as LIBOR Rises

  • Consequences of MedStat not executing a swap under changing market conditions.

Appendix 11: Interest Rate Swap Quotes

  • Detailed swap rate quotes across multiple currencies (December 31, 2014).

Appendix 12: MedStat's Cross-Currency Swap Flowchart

  • Comprehensive cash flow analysis relating to the currency swap agreements and related conversions.