MODULE 5: SWAPS

Contents
Interest rate swaps
Currency swaps

Interest Rate Swaps

It is an agreement between two parties to
exchange interest payments in a specific
currency for a specific maturity on an agreed
upon notional principal
Notional implies that the principal is a
theoretical value used for interest calculation
It is a reference amount on which interest is
calculated hence it is same for both parties
The principal amount is never exchanged
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Interest Rate Swaps

Most swap transactions fall within 2
10 year maturity periods
Two main types:
1. Fixed for Floating rate swap: also
called Coupon swaps
2. Floating for Floating rate swap:
interest payments based on
different reference rates: also called
Basis swaps
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IRS: Eg. Adapted from Alan Shapiro

Parties A & B both require USD 100 m for a 5year period. Party A has a credit rating of BBB
whereas Party B has a rating of AAA
A would like to borrow at a fixed rate whereas
B would like to borrow at a floating rate
A can raise funds at a fixed rate of 8.5% or at a
floating rate of 6-month LIBOR + 0.5%
B can raise funds at a fixed rate of 7.0% or at a
floating rate of 6-month LIBOR
Structure a swap transaction between A & B
that is mutually beneficial to them
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IRS: Adapted From Eg. from Alan

Shapiro
Borrowing
Party

Fixed
Rate
Available
A: BBB rated 8.5%

B: AAA rated 7.0%

Difference: A 1.5%
-B

Floating
Rate
Available
6-month
LIBOR +
0.5%
6-month
LIBOR
0.5%
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IRS: Eg.
Co. B with superior credit rating has an
advantage over Co. A in both fixed rate
market & floating rate market
However Bs advantage over A is greater in
the fixed rate market because the credit
spread between BBB & AAA ratings is higher
& more beneficial for B there
As disadvantage wrt B is lesser in the
floating rate market because the credit
spread between BBB & AAA ratings is lower &
more beneficial for A there
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IRS: Eg.
The advantage which B has over A in both
markets is called absolute advantage it is
the advantage per se without any
comparison with other markets
A comparison between the absolute
advantages / disadvantages across markets
is called Comparative advantage
If firm B has a higher absolute advantage in
market 1 than in market 2 then B is said to
have a comparative advantage in market 1
If firm A has a lower absolute disadvantage
in market 2 than in market 1 then A is said
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IRS: Eg.
Co. B with superior credit rating has an
absolute advantage over Co. A in both fixed
rate market & floating rate market
B has a comparative advantage in the fixed
rate market because its absolute advantage
is higher & more beneficial for itself there
A has a comparative advantage in the
floating rate market because its absolute
disadvantage is lower & more beneficial for
itself there
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IRS: Eg. : What should the firms do?

Each firm should borrow in the market in
which it has a comparative advantage
B should borrow in fixed rate market & A
should borrow in floating rate market
Interest savings = 1.5% - 0.5% = 1.0%
Then they should share the benefits in
terms of savings in interest payments by
exchanging swap payments
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IRS: Eg. : What should the firms do?

Since A prefers a fixed rate funding it
should pay a maximum 8.5% fixed
Since B prefers a floating rate funding it
should pay a maximum 6-month LIBOR
Since A & B both are borrowing against
their needs they can use swap to convert
the borrowing into one that suits their
needs
Potential interest savings from swap =
1%
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IRS: Eg. : What should the firms do?

Potential interest savings from swap = 1%
If they share the benefits equally then
each one would reduce interest rates by
0.5%
For A: Effective cost of fixed rate financing
(after the swap) should be: 8.5% - 0.5% =
8%
For B: Effective cost of floating rate
financing (after the swap) should be:
LIBOR 0.5%
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IRS: Eg. : What should the firms do?

LIBOR
A

B
7.5%

LIBOR +
0.5%
Floating
rate
lenders
Net Cost = LIBOR +
0.5% + 7.5% LIBOR =
8.0%

7%

Fixed rate
lenders
Net Cost =
LIBOR + 7% - 7.5%
= LIBOR 0.5%

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IRS: Cost of Intermediation

In the previous swap transaction you
have acted as a consultant and
structured the swap
However you did not take any fee
Suppose you represent Max Bank
Max Bank would charge a fee of
0.10% for the above service; B
agrees to sacrifice 0.25%, A wants
additional benefit of 0.15%
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IRS: With Intermediary Charging Fee

7.35
%
Max
Bank

A
LIBO
R
LIBOR +
0.5%
Floating
rate
lenders
Net Cost = LIBOR +
0.5% + 7.35% LIBOR =
7.85%

7.25
%
B
LIBO
R

Net Profit = 7.35% +

LIBOR LIBOR
7.25% = 0.10%

7%

Fixed rate
lenders
Net Cost =
LIBOR + 7% 7.25% = LIBOR
0.25%

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Currency Swaps
Designed to manage both interest
rate & exchange rate risks
Involves an exchange of debt
service obligations (DSO)
denominated in different currencies
Cash flows relating to the DSO of
debts denominated in different
currencies are swapped to effect
cash flows in a desired currency
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Currency Swaps
The two loans that comprise currency swap
have parallel interest & principal repayment
schedules
At each payment date interest in one
currency is exchanged for interest in
another currency
Counterparties also exchange principal
amounts at the start & end of swap
Because the periodic exchange of currencies
is fixed the currency swap is equivalent to a
package of forward contracts in currencies
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Currency Swaps (CS)

Counterparties in a CS are
concerned about their all-in-cost
(AIC)
AIC is the effective interest rate on
the money they have raised which is
equal to the discount rate at which
the present value of future interest
& principal payments is equal to the
net proceeds received by the issuer
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Currency Swaps (CS)

Right to offset: Each party has the
right to offset any non-payment of
principal or interest with a comparable
non-payment
This is required in order to release one
party from the contractual obligations
when the other party has defaulted
A currency swap is not a loan so it
does not appear as a liability on the
balance sheets of the counterparties
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Currency Swaps (CS)

Major difference between CS &
IRS is that in a CS there is always
an exchange of principal amounts
at the beginning & at maturity at
a predetermined exchange rate
Swap contract becomes like a
long-dated forward exchange rate
contract where the forward rate is
the current spot rate
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Currency Swaps (CS)

Fixed-for-fixed CS
Fixed-for-floating CS

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Eg: Fixed-for-Fixed CS: Eg. from Shapiro

Dow Chemical (DC) has some exposure in Euro
& wants to hedge the same by borrowing in
Euro
Michelin (MC) wants to finance its new
investments in US by USD loan
DC can raise USD debt at a coupon rate of
7.5% or Euro debt at a coupon rate of 8.25%
MC can raise USD loan at 7.7% & Euro loan at
8.1%
Both want equivalent of USD 200 m fixed rate
financing for 10 years
22
Current EUR-USD spot rate: EUR 1.1/USD

CS: Eg. Adapted from Alan Shapiro

Borrowing
Party
DC (US)
MC (Fr.)
Difference

USD Rate

Euro Rate

7.5%
7.7%
20 bps

8.25%
8.1%
15 bps

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Fixed-for-Fixed CS: Eg. from Shapiro

Current EUR-USD spot rate: EUR 1.1/USD
Both cos. want USD 200m equ. of financing
It is cheaper for DC to borrow in USD & for
MC to borrow EUR
Each co. desires that form of loan that is
more expensive for it
So DC should borrow in USD & MC should
borrow in EUR & then they should swap
DC should borrow USD 200m at 7.5% & MC
should borrow 200*1.1 = EUR 220m at 8.1%
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Fixed-for-Fixed CS: Eg. Adapted from Shapiro

Benefit of this swap would be that:

DC would be effectively
borrowing in EUR @ 8.1% instead
of 8.25% that is applicable to it
MC would be effectively
borrowing in USD @ 7.5% instead
of 7.7% that is applicable to it
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Fixed-for-Floating CS: Eg.

from Alan Shapiro
Borrowing
Party
DC (US)

USD Rate

MC (Fr.)

7.7%

Difference

20 bps

7.5%

Euro Rate
(Floating)
LIBOR +
0.35%
LIBOR+0.12
5%
22.5 bps
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Fixed-for-Floating CS: Eg. from Shapiro

Current EUR-USD spot rate: EUR 1.1/USD
Both cos. want USD 200m equ. of financing
It is cheaper for DC to borrow in USD & for
MC to borrow EUR
Each co. requires that form of loan that is
more expensive for it
So DC should borrow in USD & MC should
borrow in EUR & then they should swap
DC should borrow USD 200m at 7.5% & MC
should borrow 200*1.1 = EUR 220m at
LIBOR + 0.125%
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Fixed-for-Floating CS: Eg. Adapted from Shapiro

In practice a commercial bank /

investment bank would be intermediary
The intermediary would charge a fee
Intermediary could be either a broker or a
dealer
If it acts as a broker it would just arrange
the transaction
If it acts as a dealer it would also
guarantee swap payments to both parties
Dealer must have a high credit rating
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Reasons for Swaps

Credit spread differential: Differences
existing in financial markets, in the
perception of compared credit quality
between firms with different credit
ratings
Market saturation: A specific market
becomes saturated with paper from one
particular issuer only
Different financial norms: Different
countries may have different norms of
acceptable parameters of credit
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