September 27, 2022

In international finance, monetary exchanges are a constant event. Interest rate and currency swaps are two forms of exchanging cash flow. Interest rate swaps occur when money is exc

In international finance, monetary exchanges are a constant event. Interest rate and currency swaps are two forms of exchanging cash flow. Interest rate swaps occur when money is exchanged over a contract that has fixed obligations within the same currency. Currency swaps have the same contractual obligations, however, they occur when money is exchanged across the different currencies.

Consider when it would be best for a company to use both types of financial swaps. With these thoughts in mind, address the following:

Evaluate how businesses and investors use an interest rate swap or a currency swap as a hedging strategy.
In your opinion, when should a business or investor use an interest rate swap and a currency swap? Support your response with this week’s Learning Resources.

By Day 4

Reada brief statement.

Read a selection of your colleagues' postings.

Interest Rate and Currency Swaps

Chapter Fourteen

CHAPTER 14 covers interest rate and currency swaps, useful tools for hedging long-term interest rate and currency risk.

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?

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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

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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

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EXHIBIT 14.1 Size of OTC Interest Rate and Currency Swap Markets: Total Notional Principal Outstanding Amounts in Billions of U.S.D.

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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

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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

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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

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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.

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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.

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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

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EXHIBIT 14.3 Calculation of Quality Spread Differential

A QSD is the difference between the default-risk premium differential on the fixed-rate debt and the default-risk premium differential on the floating-rate debt. Typically, the former is greater than the latter.

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EXHIBIT 14.4 Fixed-for-Floating Interest Rate Swap

Exhibit 14.4 diagrams a possible scenario the swap bank could arrange for the two counterparties.

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.

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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%

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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.

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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

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In order not to complicate this example any more than is necessary, it is assumed that the bid and ask swap rates charged by the swap bank are the same; that is, there is no bid-ask spread. This assumption is relaxed in a later example.

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EXHIBIT 14.5 Interest Savings from Comparative Advantage

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EXHIBIT 14.6 $/€ Currency Swap

There is a combined total of 2 percent that can be saved or earned through the currency swap, 1 percent on the dollar notional amount, and 1 percent on the equivalent euro notional value.

There is a cost savings for each counterparty because of their relative comparative advantage in their respective national capital markets.

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

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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

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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

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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)

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If the positive QSD is one of the primary reasons for the existence of interest rate swaps, one would expect arbitrage to eliminate it over time and that the growth of the swap market would decrease. Quite the contrary has happened. Thus, the arbitrage argument does not seem to have much merit.

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

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Futures and Options on Foreign Exchange

Chapter 7

Chapter Outline

Futures Contracts: Some Preliminaries

Currency Futures Markets

Basic Currency Futures Relationships

Options Contracts: Some Preliminaries

Currency Options Markets

Currency Futures Options

Basic Option-Pricing Relationships at Expiration

American Option-Pricing Relationships

European Option-Pricing Relationships

Binomial Option-Pricing Model

European Option-Pricing Model

Empirical Tests of Currency Options

Summary

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BIG chapter

Futures Contracts: Preliminaries

Both forward and futures contracts are derivative or contingent claim securities because their values are derived from or contingent upon the value of the underlying security

Forward contract

Tailor-made for a client by their international bank

Futures contract

Standardized features (e.g., contract size, maturity date, delivery months)

Exchange traded

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Futures Contracts: Preliminaries (Continued)

An initial performance bond (formerly called margin) must be deposited into a collateral account to establish a futures position

Generally equal to 2% of contract value

Cash or T-bills may be used to meet requirement

Major difference between forward contract and futures contract is the way the underlying asset is priced for future purchase or sale

Forward contract states a price for the future transaction, but futures contract is settled-up, or marked-to-market, daily at the settlement price

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The settlement price is a price representative of futures transaction prices at the close of daily trading on the exchange. It is determined by a settlement committee for the commodity, and it may be somewhat arbitrary if trading volume for the contract has been light for the day.

Differences between Futures and Forward Contract

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Currency Futures Markets

Trading in currency futures began at the Chicago Mercantile Exchange (CME) on May 16, 1972

2 million contracts traded in 1978

230 million contracts traded in 2018

CME Group formed in 2007, through a merger between the CME and Chicago Board of Trade (CBOT)

In 2008, CME Group acquired the New York Mercantile Exchange (NYMEX)

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Currency Futures Markets (Continued)

Most CME currency futures trade in a March, June, September, and December expiration cycle out six quarters into the future, with the delivery date being the third Wednesday of the expiration month

Last day of trading for most contracts is the second business day prior to the delivery date

Trading takes place Sunday through Friday on the GLOBEX trading system from 5:00 PM to 4:00 PM Chicago time the next day

Currency futures trading takes place on other exchanges, in addition to the CME

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Basic Currency Futures Relationships

Information provided on quotes for CME futures contracts includes the following:

Opening price, high and low quotes for the trading day, settlement price, and open interest

Open interest is the total number of short or long contracts outstanding for the particular delivery month

Futures are prices very similarly to forward contracts

Recall from chapter 6, the IRP model states the forward price for delivery at time T is:

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We will use the same equation to define the futures price.

Option Contracts: Some Preliminaries

An option is a contract giving the owner the right, but now the obligation, to buy or sell a given quantity of an asset at a specified price at some time in future

Option to buy is a call, and option to sell is a put

Buying or selling the underlying asset via the option is know as “exercising” the option

Stated price paid or received is known as the exercise or striking price

Buyer of an option is often referred to as the long, and the seller of an option is referred to as the writer (or the short)

European option can be exercised only at maturity or expiration date of contract, but American option can be exercised any time during contract

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Four main positions are as follows: call writer, call buyer, put writer, and put buyer

Currency Option Markets

Prior to 1982, all currency option contracts were OTC options written by international banks, investment banks, and brokerage houses

OTC options are tailor-made and generally for large amounts (i.e., at least $1m of currency serving as underlying assets)

OTC options are typically European style, and they are often written for U.S. dollars, with the euro, British pound, Japanese yen, Canadian dollar, and Swiss franc serving as the underlying currency

In December 1982, Philadelphia Stock Exchange (PHLX) began trading options on foreign currency

In 2008, PHLX was acquired by NASDAQ OMX Group

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The volume of OTC currency options trading is much larger than that of organized-exchange option trading.

Currency Futures Options

CME Group trades European style options on several of the currency futures contracts it offers

With these, the underlying asset is a futures contract on the foreign currency instead of the physical currency

One futures contract underlies one options contract

Most CME futures options trade with expirations in the March, June, September, December expiration cycle of the underlying futures contract and three serial noncycle months

Options expire on the second business day prior to the third Wednesday of the options contract month

Trading takes place Sunday through Friday on the GLOBEX system from 5:00 PM to 4:00 PM Chicago time the next day

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Options on currency futures behave very similarly to options on the physical currency since the futures price converges to the spot price as the futures contract nears maturity.

Basic Option-Pricing Relationships at Expiration

At expiration, a European option and an American option (which has not been previously exercised), both with the same exercise price, will have the same terminal value

For call options the time T expiration value per unit of foreign currency is stated as the following:

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Equation definitions

CaT denotes the value of the American call at expiration

CeT is the value of the European call at expiration

E is the exercise price per unit of foreign currency

ST is the expiration date spot price

Max is an abbreviation for denoting the maximum of the arguments within the brackets

Basic Option-Pricing Relationships at Expiration (Continued)

Call (put) option with ST > E (E > ST) expires in-the-money

It will

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