Interest Rate and Currency Swaps Essay Example

Interest Rate and Currency Swaps Paper CHAPTER 14 INTEREST RATE AND CURRENCY SWAPS SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS I. Describe the difference between a swap broker and a swap dealer. Answer: A swap broker arranges a swap between two counterparts for a fee without taking a risk position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in matching opposite sides of a swap and in assuring that each counterparts fulfills its contractual obligation to the other. 2. What is the necessary condition for a fixed-for-floating interest rate swap to be Seibel? Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. In general, the default-risk premium of the taxed-rate debt will be larger than the default-risk premium tot the floating- rate debt. 3. Discuss the basic motivations for a counterparts to enter into a currency swap. Answer: One basic reason for a counterparts to enter into a currency swap is to exploit the comparative advantage of the other in obtaining debt financing at a lower interest rate than could be obtained on its own. A second basic reason is o lock in long-term exchange rates in the repayment Of debt service Obligations denominated in a foreign currency. 4. How does the theory of comparative advantage relate to the currency swap market? Answer: Name recognition is extremely important in the international bond market. Without it, even a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds than a local borrower of equivalent creditworthiness. We will write a custom essay sample on Interest Rate and Currency Swaps specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Interest Rate and Currency Swaps specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Interest Rate and Currency Swaps specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Consequently, two firms of equivalent creditworthiness can each exploit their, respective, name recognition by borrowing in their local capital racket at a favorable rate and then re-lending at the same rate to the other, S, Discuss the risks confronting an interest rate and currency swap dealer. Answer: An interest rate and currency swap dealer confronts many different types of risk. Interest rate risk refers to the risk of interest rates changing unfavorable before the swap dealer can lay off on an opposing counterparts the unplaced side of a swap with another counterparts. Basis risk refers to the floating rates Of two counterparts being pegged to two different indices. In this situation, since the indexes are not perfectly positively correlated, the swap ann. may not always receive enough floating rate funds from one counterparts to pass through to satisfy the other side, while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes the bank to lay off a swap it undertakes on an opposing counterparts before exchange rates change. Additionally, the dealer confronts credit risk from one counterparts defaulting and its having to fulfill the defaulting partys obligation to the other counterparts. Mismatch risk refers to the difficulty of the dealer finding an exact opposite attach for a swap it has agreed to take. Sovereign risk refers to a country imposing exchange restrictions on a currency involved in a swap making it costly, or impossible, for a counterparts to honor its swap obligations to the dealer. In this event, provisions exist for the early tear-nation of a swap, which means a loss of revenue to the swap bank. 6. Briefly discuss some variants of the basic interest rate and currency swaps diagramed in the chapter, Answer: Instead of the basic fixed-for-floating interest rate swap, there are also zero-coupon-for-floating rate swaps where the fixed rate payer makes only one error-coupon payment at maturity on the notional value. There are also floating- for-floating rate swaps where each side is tied to a different floating rate index or a different frequency Of the same index. Currency swaps need not be fixed- for-fixed: fixed-formatting and floating-for-floating rate currency swaps are frequently arranged. Moreover, both currency and interest rate swaps can be amortizing as well as non-amortizing. 7. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets, what other explanations exist to explain the rapid velveteen of the interest rate swap market? Answer: All types of debt instruments are not always available to all borrowers. Interest rate swaps can assist in market completeness. That is, a borrower may use a swap to get out of one type of financing and to obtain a more desirable type tot credit that is more suitable for its asset maturity structure. . Suppose Morgan Guaranty, Ltd. Is quoting swap rates as follows: 7. 75 8. 10 percent annually against six-month dollar LABOR for dollars and II II percent annually against six-month dollar LABOR for British pound sterling. At hat rates will Morgan Guaranty enter into a $/E currency swap? Answer: Morgan Guaranty will pay annual fixed-rate dollar payments of 75 percent against receiving six-month dollar LABOR flat, or it will receive fixed-rate annual dollar payments at 8. 10 percent against paying six-month dollar LABOR flat. Morgan Guaranty will make annual fixed-rate E payments at 1 1. 25 percent against receiving six-month dollar LABOR flat, or it Will receive annual fixed-rate E payments at 11. 65 percent against paying six-month dollar LABOR flat. Thus, Morgan Guaranty Will enter into a currency swap in Which it would pay annual axed-rate dollar payments of 7. 75 percent in return for receiving semi-annual fixed-rate E payments at II . 65 percent, or it Will receive annual fixed-rate dollar payments at 8. 0 percent against paying annual fixed-rate E payments at 11. 25 percent. 9. A U. S. Company needs to raise It plans to raise this money by issuing dollar- denominated bonds and using a currency swap to convert the dollars to euros. The Corcoran expects interest rates in both the United States and the Euro zone to fall. A. Should the swap be structured with interest paid at a fixed or a floating rate? B. Should the swap be structured with interest received at a fixed or a floating rate? SFA Guideline Answer: a. The U. S. Many would pay the interest rate in euros. Because it expects that the interest rate in the Euro zone Will fall in the future, it should choose a swap with a floating rate on the interest paid in euros to let the interest rate on its debt float down. B. The US. Company would receive the interest rate in dollars. Because it expects that the interest rate in the United States will fall in the future, it should choose a swap with a fixed rate on the interest received in dollars to prevent the interest ate it receives from going down, *10. Assume a currency swap in which two counterparts of comparable credit risk each borrow at the best rate available, yet the nominal rate of one counterparts is higher than the other, After the initial principal exchange, is the counterparts that is required to make interest payments at the higher nominal rate at a financial disadvantage to the other in the swap agreement? Explain your thinking. Answer: Superficially, it may appear that the counterparts paying the higher nominal rate is at a disadvantage since it has borrowed at a lower rate. However, f the forward rate is an unbiased predictor of the expected spot rate and if RIP holds, then the currency with the higher nominal rate is expected to depreciate versus the other. In this case, the counterparts making the interest payments at the higher nominal rate is in effect making interest payments at the lower interest rate because the payment currency is depreciating in value versus the borrowing currency. PROBLEMS I. Alpha and Beta Companies can borrow for a five-year term at the following rates: Alpha Beta Moodys credit rating Fixed-rate borrowing cost 12. 0% Floating-rate borrowing cost LABOR LABOR* a. Calculate the quality spread differential (SD). B. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating. Rate debt and Beta desires fixed-rate debt. No swap bank is involved in this transaction. Solution: a. The SD (12. 0% 10. 5%) minus (LABOR * LIBIDO- . 5%. B. Alpha needs to issue fixed-rate debt at and Beta needs to issue floating rate-debt at BOOR 1%. Alpha needs to pay LABOR to Beta. Beta needs to pay 10 75% to Alpha. It this is done, Alphas floating-rate all-in-cost is: 4 LABOR 10. 5% = LABOR . 25% savings over issuing floating-rate debt on its own. Betas fixed-rate all-in- cost is: LIBIDO 1% 10. 75% LABOR 11. 75%, a savings over issuing fixed- 2. Do problem 1 over again, this time assuming more realistically that a swap bank is involved as an intermediary. Assume the swap bank is quoting five-year dollar interest rate swaps at 10. 7% 10. 8% against LABOR flat. Alpha will issue fixed-rate debt at 10. 5% and Beta will issue floating rate-debt at LABOR * 1%. Alpha Will receive 10. 7% from the swap bank and pay it LABOR. Beta Will pay 10. % to the swap bank and receive from it LABOR. If this is done, Alphas floating- rate all. In. Cost is: 10. 5% LABOR 10. 7% LABOR . .20%, a . 20% savings over issuing floating-rate debt on own. Betas fixed-rate Allan-cost is: LIBIDO 10. 8% LABOR 1 1. 8%, a . 20% savings over issuing fixed. Rate debt. 3. Company A is a Aerated firm desiring to issue five-year Ferns. It finds that it Gang issue Erne at six-month LABOR . 125 percent or at three-month LABOR * . 125 percent. Given its asset structure, three-month LABOR is the preferred index, Company B is an A-rated firm that also desires to issue verifier Pros. It finds it can issue at six-month LABOR + 1. Percent or at three-month LABOR + . 625 percent. Given its asset structure, six-month LABOR is the preferred index. Assume a notional principal of Determine the SD and set up a floating-for-floating rate swap where the swap bank receives , 125 percent and the two counterparts share the remaining savings equally. Solution: The quality spread differential is [(Six-month Al BOOR + 1. 0 percent) minus (Six-month LABOR . 125 percent) z] _875 percent minus [(Three-month LABOR * . 625 percent) minus (Three-month LABOR -e . 25 percent) . 50 percent, which equals 375 percent. If the swap bank receives . 25 percent, each counterparts is to save . 125 percent. To affect the swap, Company A would issue Ferns indexed to six-month LABOR and Company B would issue Erne indexed three-month LABOR. Company B might make semi-annual payments of six-month LABOR 125 percent to the swap bank, which would pass all of it through to Company A. Company A, in turn, might make quarterly payments of three-month LABOR to the swap bank, which would pass through three-month LABOR . ASS percent to Company B. On an annulled basis, Company B will remit to the swap bank six- month LABOR * . 125 percent and pay three-month LABOR . 25 percent on its Ferns. It will receive three-month LABOR , 125 percent from the swap bank. This arrangement results in an all-in cost of six-month LABOR . 825 percent, which is a rate . 125 percent below the F-Runs indexed to six-month LABOR 4 percent Company B could issue on its own. Company A will remit three-month LABOR to the swap bank and pay six-month LABOR 4 . 1 AS percent on its Ferns. It will receive six-month LABOR + . 125 percent from the swap bank. This arrangement results in an all-in cost of three-month LABOR for Company A, which is _ 125 percent less than the Ferns indexed to three-month LABOR + . 25 percent it could issue on its own. The arrangements with the two counterparts net the swap bank . 1 AS percent per annum, received quarterly. A corporation enters into a five-year interest rate swap with a swap bank in which it agrees to pay the swap bank a fixed rate of 3. 75 percent annually on a notional amount of and receive LABOR. As of the second reset date, determine the price of the swap from the corporations viewpoint assuming that the fixed-rate side Of the swap has increased to 10. 25 percent. Solution: On the reset date, the present value Of the future floating-rate aments the corporation will receive from the swap bank based on the notional value Will be The present value Of a hypothetical bond issue Of ?15,000. 000 with three remaining 9. 75 percent coupon payments at the new fixed. Rate of 10. 25 percent is ?1 This sum represents the present value of the remaining payments the swap bank will receive from the corporation. Thus, the swap bank should be willing to buy and the corporation should be willing to sell the swap for = ?185,696. 5. Karl Ferris, a fixed income manager at Angus Capital Management, expects the current positively sloped U. S. Treasury yield curve to shift parallel upward. Ferris owns two $1 corporate bonds maturing on June 15, 1999, one with a variable rate based on 6-month LIST. Dollar LABOR and one with a fixed rate. Both yield SO basis points over comparable IS_S. Treasury market rates, have very similar credit quality, and pay interest semi-annually. Ferris wished to execute a swap to take advantage of her expectation of a yield curve shift and believes that any difference in credit spread between LABOR and LLC. S. Treasury market rates will remain constant. A. Describe a six-month U. S. Dollar LABOR-based swap that would allow Ferris o take advantage Of her expectation. Discuss, assuming Ferris expectation is correct, the change in the swaps value and how that change would affect the value Of her portfolio. [NO calculations required to answer part a. ] Instead Of the swap described in part a, Ferris would use the following alternative derivative strategy to achieve the same result. . Explain, assuming Ferris expectation is correct, how the following strategy achieves the same result in response to the yield curve shift. [No calculations required to answer part b. ] Settlement Date 1215-97 03-15-98 0615-98 09-15-98 12-15-98 03-15-99 Nominal Arteriolar Futures Contract Value 1000. 000 c. Discuss one reason why these two derivative strategies provide the same result. SFA Guideline Answer a. The Swap Value and its Effect on Ferris Portfolio Because Karl Ferris believes interest rates will rise, she will want to swap her fixed-rate corporate bond interest to receive six-month U. S. Dollar LABOR, She will continue to hold her variables six-month U. S. Dollar LABOR rate bond because its payments will increase as interest rates rise. Because the credit risk between the U. S. Dollar LABOR and the US. Treasury market is expected to main constant, Ferris can use the LIST. Dollar LABOR market to take advantage tot her interest rate expectation without affecting her credit risk exposure. To execute this swap, she would enter into a two-year term, semi-annual settle, nominal principal, pay fixed-receive floating IS. S, dollar LABOR swap. If rates rise, the swaps mark-to-market value will increase because the U. S. Dollar LABOR Ferris receives will be higher than the LABOR rates from which the swap was priced. If Ferris were to enter into the same swap after interest rates rise, she would pay a higher fixed rate to receive LABOR rates. This higher fixed rate valued be calculated as the present value of now higher forward LABOR rates. Because Ferris would be paying a stated fixed rate that is lower than this new higher- present-value fixed rate, she could sell her swap ATA premium. This premium is called the replacement cost value Of the swap. B. Arteriolar Futures Strategy The appropriate futures hedge is to short a combination of Arteriolar futures contracts with different settlement dates to match the coupon payments and principal. This futures hedge accomplishes the same objective as the pay fixed-receive floating swap described in Part a. By discussing how the yield- curve shift affects the value of the futures hedge, the candidate can show an understanding of how Arteriolar futures contracts can be used instead of a pay fixed-receive floating swap. It rates rise, the mark-to-market values of the Arteriolar contracts decrease; their yields must increase to equal the new higher forward and spot LABOR rates. Because Ferris must short or sell the Arteriolar contracts to duplicate the pay fixed-receive variable swap in part a, she gains as the Arteriolar futures contracts decline in value and the futures hedge increases in value. As the contracts expire, or if Ferris sells the remaining contracts prior to maturity, she will recognize a gain that increases her return. With higher interest rates, the value of the fixed-rate bond will decrease. Fifth hedge ratios are appropriate, the value of the portfolio, however, will remain unchanged because of the increased value of the hedge, which offsets the fixed-rate bonds decrease. Why the Derivative Strategies Achieve the Same Result Arbitrage market forces make these bono strategies provide the same result to Ferris. The two strategies are different mechanisms for different market artisans to hedge against increasing rates. Some money managers prefer swaps; others, Arteriolar futures contracts. Each institutional market participant has different preferences and choices in hedging interest rate risk, The key is that market makers moving into and out of these two markets ensure that the markets are similarly priced and provide similar returns. As an example of such an arbitrage, consider what would happen it tankard market LABOR rates were lower than swap market LABOR rates. An arbitrageur would, under such circumstances, sell the futures/bombard contracts and enter into a received fixed-pay variable swap. This arbitrageur could now receive the higher fixed rate of the swap market and pay the lower fixed rate of the futures market. He or she would pocket the differences between the two rates (without risk and without having to make any [net] investment. ) This arbitrage could not last. As more and more market makers sold Arteriolar futures contracts, the selling pressure would cause their prices to fall and yields to rise, Which would cause the present value cost of selling the Arteriolar contracts also to increase. Similarly, as more and more market makers offer to receive fixed rates in the swap market, market Akers would have to lower their fixed rates to attract customers so they could lock in the lower hedge cost in the Arteriolar futures market. Thus, Arteriolar forward contract yields would rise and/or swap market receive-fixed rates would fall until the two rates converge. At this point, the arbitrage opportunity would no longer exist and the swap and forwards/futures markets would be in equilibrium. 6. Rene Company asks Paula Scott, a treasury analyst, to recommend a flexible way to manage the companys financial risks. Two years ago, Rene issued a $25 million (U. S. ), five-year floating rate note (FRR). The PORN pays an annual coupon equal to one-year LABOR plus 75 basis points, The FRR is non-callable and will be repaid at par at maturity. Scott expects interest rates to increase and she recognizes that Rene could protect itself against the increase by using a pay-fixed swap. However, Renees Board of Directors prohibits both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combination of capital market instruments. A. Identify the instruments needed by Scott to replicate a pay-fixed swap and scribe the required transactions. B. Explain how the transactions in Part a are equivalent to using a pay-fixed a. The instruments needed by Scott are a fixed-coupon bond and a floating rate note (PORN). The transactions required are to: ; issue a fixed-coupon bond with a maturity of three years and a notional amount of $25 million, and ; buy a $25 million FRR of the same maturity that pays one-year LABOR plus 75 BSP. B. At the outset, Rene will issue the bond and buy the FRR, resulting in a zero net cash flow at initiation. At the end of the third year, Rene will repay the fixed- upon bond and will be repaid the FRR, resulting in a zero net cash flow at maturity, The net cash flow associated with each of the three annual coupon payments will be the difference between the inflow (to Rene) on the FRR and the outflow (to Rene) on the bond. Movements in interest rates during the three-year period will determine whether the net cash flow associated with the coupons is positive or negative to Rene_ Thus, the bond transactions are financially equivalent to a plain vanilla pay-fixed interest rate swap. A company based in the United Kingdom has an Italian subsidiary. The subsidiary generates ?25,000,000 a year, received in equivalent semiannual installments of The British company wishes to convert the Euro cash flows to pounds twice a year. It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the euros to pounds. The current exchange rate is ?1. 5/E. The fixed rate on a plain vanilla currency swap in pounds is 7. 5 percent per year, and the fixed rate on a plain vanilla currency swap in euros is 6. 5 percent per year. A. Determine the notional principals in euros and pounds tort a swap with semiannual payments that will help achieve the objective. B. Determine the semiannual cash flows from this swap. CPA Guideline Answer a. The semiannual cash flow must be converted into pounds is ?12,500,000. In order to create a swap to convert ?12,500,000, the equivalent notional principals are Euro notional principal ?12, 065/2) Pound notional principal = = IOWA,257 b. The cash flows from the swap will now be ; company makes swap payment = = Company receives Swap payment = = The company has effectively converted Euro cash receipts to pounds. 8. Gaston Bishop is the debt manager for World Telephone, Which needs ?3. 33 billion Euro financing for its operations. Bishop is considering the choice between issuance of debt denominated in: [I Euros or U. S. Lars, accompanied by a combined interest rate and currency swap. A. Explain one risk World would assume by entering into the combined interest rate and currency swap. Bishop believes that issuing the u. S. -dollar debt and entering into the swap can lower Worlds cost of debt by 45 basis points. Immediately after selling the debt issue, World would swap the U. S. Dollar payments for Euro payments throughout the maturity of the debt. She assumes a constant currency exchange rate throughout the tenor of the swap. Exhibit 1 gives details tort the two alternative debt issues.