INTERNATIONAL FINANCIAL MANAGEMENT

INTEREST RATE AND CURRENCY SWAPS

 Chapter Outline
• Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Swap Market Quotations
• Interest Rate Swaps
• Currency Swaps
• Variations of Basic Interest Rate and Currency Swaps
• Risks of Interest Rate and Currency Swaps
• Is the Swap Market Efficient?

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-2
 Types of Swaps
• In interest rate swap financing, two parties, called
counterparties, make a contractual agreement to
exchange cash flows at periodic intervals
• Two types of interest rate swaps:
– Single-currency interest rate swaps (i.e., interest rate
swaps) involve swapping interest payments on debt
obligations that are denominated in the same currency
– In a cross-currency interest rate swap (i.e., currency
swap), one counterparty exchanges the debt service
obligations of a bond denominated in one currency for the
debt service obligations of the other counterparty that are
denominated in another currency
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-3
 Size of the Swap Market
• Market for currency swaps developed first, but the
interest rate swap market is larger, where size is
measured by notional principal
• In 2018, the notational principal was as follows:
– Interest rate swaps at $326,690 billion USD
– Currency swaps at $24,858 billion USD
• The five most common currencies used to
denominate interest rate and currency swaps were the
following:
– U.S. dollar, euro, Japanese yen, the British pound sterling,
and the Canadian dollar

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-4
EXHIBIT 14.1
Size of OTC Interest Rate and Currency Swap Markets: Total Notional Principal Outstanding
Amounts in Billions of U.S.D.

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-5
 The Swap Bank
• Swap bank is a generic term to describe a
financial institution that facilitates swaps
between counterparties
– Can be international commercial bank, investment
bank, merchant bank, or independent operator
– Serves as either a swap broker or swap dealer
• As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap
• As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay it off, or
match it with a counterparty
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-6
 Swap Market Quotations

• Swap banks will tailor the terms of interest

rate and currency swaps to customers’ needs.
• They also make a market in “plain vanilla”
swaps and provide quotes for these and
provide current market quotations applicable
to counterparties with Aa or Aaa credit ratings

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-7
 Swap Market Quotations (Continued)
• It is convention for swap banks to quote interest rate
swap rates for a currency against a local standard
reference in the same currency and currency swap rates
against dollar LIBOR
– For example, for a five-year swap with semiannual payments in
Swiss francs, suppose the bid-ask swap quotation is 6.60–6.70
percent against six-month LIBOR flat
– This means the swap bank will pay semiannual fixed-rate SFr
payments at 6.60 percent against receiving six-month SFr (dollar)
LIBOR in an interest rate (a currency) swap, or it will receive
semiannual fixed-rate SFr payments at 6.70 percent against paying
six-month SFr (dollar) LIBOR in an interest rate (a currency) swap
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-8
 Basic Interest Rate Swap: Bank A
• Consider the following example of a fixed-for-floating
rate swap:
– Bank A is a AAA-rated international bank located in the
United Kingdom. The bank needs $10,000,000 to finance
floating-rate Eurodollar term loans to its clients.
– It is considering issuing five-year floating-rate notes indexed
to LIBOR. Alternatively, the bank could issue five-year
fixed-rate Eurodollar bonds at 10 percent.
• The FRNs make the most sense for Bank A.
• In this manner, the bank avoids the interest rate risk associated with a
fixed-rate issue.
• Without this hedge, Bank A could end up paying a higher rate than it
is receiving on its loans should LIBOR fall substantially.

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-9
 Basic Interest Rate Swap: Company B
• Consider the following example of a fixed-for-floating
rate swap:
– Company B is a BBB-rated U.S. company. It needs
$10,000,000 to finance a capital expenditure with a five-year
economic life.
– It can issue five-year fixed-rate bonds at a rate of 11.25
percent in the U.S. bond market. Alternatively, it can issue
five-year FRNs at LIBOR plus 0.50%.
• The fixed-rate debt makes the most sense for Company B because it
locks in a financing cost.
• The FRN alternative could prove very unwise should LIBOR
increase substantially over the life of the note and could possibly
result in the project being unprofitable.
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-10
 Basic Interest Rate Swap
• A swap bank familiar can set up a fixed-for-floating
interest rate swap that will benefit each counterparty and
the swap bank
– Assume that the swap bank is quoting five-year U.S. dollar
interest rate swaps at 10.375 – 10.50 percent against LIBOR
flat
– Necessary condition is a positive quality spread differential
(QSD)
• If a positive QSD exists, it is possible for each counterparty to issue the
debt alternative that is least advantageous for it (given its financing
needs), then swap interest payments, such that each counterparty ends
up with the type of interest payment desired, but at a lower all-in cost
than it could arrange on its own
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-11
EXHIBIT 14.3
Calculation of Quality Spread Differential

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-12
 EXHIBIT 14.4
Fixed-for-Floating Interest Rate Swap

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-13
 Basic Currency Swap

• Consider the following example:

– A U.S. MNC desires to finance a capital expenditure of its German
subsidiary. The project has an economic life of five years, and the cost of
the project is €40,000,000. At the current exchange rate of $1.30/€1.00,
the parent firm could raise $52,000,000 in the U.S. capital market by
issuing 5-year bonds at 8%. The parent would then convert the dollars to
euros to pay the project cost. The German subsidiary would be expected
to earn enough on the project to meet the annual dollar debt service and to
repay the principal in five years. The only problem with this situation is
that a long-term transaction exposure is created. If the dollar appreciates
against the euro over the loan period, it may be difficult for the German
subsidiary to earn enough in euros to service the dollar loan.

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-14
 Basic Currency Swap (Continued)
• An alternative is for the U.S. parent to raise €40,000,000
in the international bond market by issuing euro-
denominated Eurobonds.
– The U.S. parent might instead issue euro-denominated foreign
bonds in the German capital market.
• However, if the U.S. MNC is not well known, it will
have difficulty borrowing at a favorable interest rate.
• Suppose the U.S. parent can borrow €40,000,000 for a
term of five years at a fixed rate of 7%. The current
normal borrowing rate for a well-known firm of
equivalent creditworthiness is 6%
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-15
 Basic Currency Swap (Concluded)

• Assume a German MNC of equivalent creditworthiness has a

mirror-image financing need.
– It has a U.S. subsidiary in need of $52,000,000 to finance a capital
expenditure with an economic life of five years.
– The German parent could raise €40,000,000 in the German bond
market at a fixed rate of 6% and convert the funds to dollars to
finance the expenditure.
– Transaction exposure is created, however, if the euro appreciates
substantially against the dollar. In this event, the U.S. subsidiary
might have difficulty earning enough in dollars to meet the debt
service. The German parent could issue Eurodollar bonds (or
alternatively, Yankee bonds in the U.S. capital market), but since it is
not well known its borrowing cost would be, say, a fixed rate of 9
percent.

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-16
 Basic Currency Swap Solution

• A swap bank could arrange a currency swap that would

solve the double problem of each MNC, that is, be
confronted with long-term transaction exposure or
borrow at a disadvantageous rate.
• The swap bank would instruct each parent firm to raise
funds in its national capital market where it is well
known and has a comparative advantage

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-17
EXHIBIT 14.5
Interest Savings from Comparative Advantage

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-18
EXHIBIT 14.6
$/€ Currency Swap

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-19
 Variations of Basic Interest Rate and Currency
Swaps

• Several variants of the basic interest rate and

currency swaps are listed below:
– Fixed-for-floating interest rate swap
– Zero-coupon-for-floating rate swap
– Floating-for-floating interest rate swap
– Amortizing currency swaps

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-20
 Risks of Interest Rate and Currency Swaps

• Major risks faced by a swap dealer:

– Interest-rate risk refers to the risk of interest rates changing
unfavorably before the swap bank can lay off on an opposing
counterparty the other side of an interest rate swap entered into
with a counterparty
– Basis risk refers to a situation in which the floating rates of the
two counterparties are not pegged to the same index
– Exchange-rate risk refers to the risk the swap bank faces from
fluctuating exchange rates during the time it takes for the bank
to lay off a swap it undertakes with one counterparty with an
opposing counterparty

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-21
 Risks of Interest Rate and Currency Swaps
(Continued)
• Major risks faced by a swap dealer:
– Credit risk refers to the probability that a
counterparty, or even the swap bank, will default
– Mismatch risk refers to the difficulty of finding an
exact opposite match for a swap the bank has agreed
to take
– Sovereign risk refers to the probability that a country
will impose exchange restrictions on a currency
involved in a swap
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-22
 Is the Swap Market Efficient?
• Two primary reasons for a counterparty to use a
currency swap:
– Obtain debt financing in the swapped currency at an interest
cost reduction (brought about through comparative
advantages each counterparty has in its national capital
market)
– Benefit of hedging long-run exchange rate exposure
• Two primary reasons for swapping interest rates:
– Better match maturities of assets and liabilities
– Obtain a cost savings (via a positive quality spread
differential)
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-23
 Is the Swap Market Efficient? (Continued)
• One must rely on an argument of market
completeness for the existence and growth of interest
rate swaps
– All types of debt instruments are not regularly available for
all borrowers
– Interest rate swap market assists in tailoring financing to the
type desired by a particular borrower
– Both counterparties can benefit (as well as the swap dealer)
through financing that is more suitable for their asset
maturity structures

Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 14-24