Currency Swaps (CSW)

Chapter 6

Currency Swaps (CSW)

Exchange mkt swap (…. Swap) – buying currency at a near date and selling it on a later date.

Here, we discuss K mkt CSW whereby two parties agree to making PMTs based on ERs – or one party makes a cash settlement (CS)

Fixed-for-Fixed Currency Swaps (FFCSW)

-annual int. PMTs are assumed (semi-ann. is most frequent)

2 Irs can agree contractually to exchg the fut. CFs from their Is – wo. an exchg of the bonds.

No t=0 exchg occurs but fut CFs are based upon a notional principal which is detd. by using spot ER at contract time

For 2 bond issues there can be a swap of t=0 prin.. amts

e.g. a US firm (IBM) issues a FF bond while a French firm (LeTrec) issues a $ bond

IBM pays proceeds of FF bond issue to LeTrec while LeTrec pays proceeds of $ bond to IBM (at t=0)

IBM would make $ int. + prin. PMTs to LeTrec which would use these to make the int. + prin. PMTs to its Irs

LeTrec would make FF int. + prin. PMTs to IBM which would use these to make the int. + prin. PMTs to its Irs.

 IBM issues a FF bond but swaps into a $ L (LeTrec issues a $ bond but swaps into a FF L)

Banks will intermediate these swaps (for a fee) which lowers costs for parties (due to lower default risk and search costs) – this has facilitated the globalization of intl. fin. mkts.

At-market CSW – where PVs of underlying notional bonds are equal

e.g. in above sit., if $ value of prin. = $1mil and X(FF/$)0= 5  FF prin. = FF5mil (in an at-mkt swap the PVs of these prin. amts would balance each other)

Cross-Currency Swaps (CCSW)

In CCSW one CF is based on a fixed coupon bond in one curr while the other CF is a based on a floating rate bond in the other curr.

These Swaps are quoted as fixed coupon bond rates against US $ LIBOR flat.

e.g. 5 yr yen at-mkt-swap: bid price = 5.10%, ask price = 5.16% (i.e. dealers B + A prices for $)

 you can receive yen at coupon rate of 5.10% and pay $ at a floating rate of LIBOR flat

-or you can pay fixed yen at 5.16% and receive $ at a floating rate of LIBOR flat

-Spread bet. bid + ask P = dealer’s profit

Interest rate swaps – a swap of fixed PMTs for floating PMTs in same curr.

e.g. of a FFCSW (at-mkt-swap)

- ex. 6-1: FFCSW receiving £ and paying $.

Notional prin. = $1mil; r$ = 5.5%; r£ = 9.8%; X($/£)0= 1.50

 pay 0.0555 ( $1mil) = $55,000 for five years plus $1mil prin.

at t = 5

OFF-MKT. SWAPS – in case where PVs of CFs are unequal  there must be a balancing t=0 PMT towards party with lower PV

-This is accomplished via a diff. check PMT

-ex. 6-2, as in ex 6-1 pay $ at 5.5% par but pay receive £s at 10% (5 yrs.) coupon (YTM on £ bond = 9%). Would you pay or receive t=0 PMT?

- NP£ = £666,667  int. received is 0.10(666.667) = £66,667

 PV of £ bond = 66,667/1.09 + 66,667/(1.09)2

+ 666,667/(1.09)3 + 66,667/(1.09)4 + 66,667/(1.09)5

+ 666,667/(1.09)5 = £692,600

 $ value = £692,600 x 1.50($/£) = $1,038,899  t=0 PMT at par = $1mil, but will receive $1,038,899 $1,038,899 - $1mil = $38,899 or $38,899/1.50($/£) = £25,932 is PMT you would have to make.

- A 5yr FFCS of 6%$ for 9%FF, X(FF/$) = 5, NP = $1mil.  int. on $ = 0.06($1mil) = 60,000 + int. in FF = 0.09(FF5mil) = FF450,000  contract ER for int. payments = FF450,000/

$60,000 = 7.5 FF/$ = CERI

-LPFF receives FF450,000 (t=1-5) + FF5 mil (t=5) (or LPFF pays $60,000)

-LP$ receives $60,000 (t=1-5) + $1mil (t+5) (or LP$ pays FF450,000)

-If X (FF/$)1 = 6  value of FF450,000 is now $75,000  CERI serves as a FWD rate which is used as a basis for diff. check settlements when there is a  spot ER

-In this case there has been an UAd app. of the FF with respect to CERI LPFF gains  using eq. 4-1

$GL = C# [ X($/FF)1 – 1/CERI]

$GL = FF450,000 [1/6(FF/$) – 1/75(FF/$)]

$GL = $15,000

 if X(FF/$)1 = CERI$GL = 0  no diff. check settlement for int. payments. But if X5 deviates from contract ER for prin. = X0 then there must be a diff. check for prin. PMTs which is separate from that for int. PMTs. If X(FF/$)5 = 6 

$GL = FF5mil [ 1/6(FF/$) – 1/5(FF/$)]

$GL = -$166,666,67  LPFF pays LP$ a diff. check of this amt. to settle prin. PMT. Whereas the net diff. check will be the diff. bet. settlements on int. + prin. PMTs

-In this case in t=5 there will be a $15,000 settlement PMT for int. to LPFF LPFF pays $166,667 - $15,000 = $151,667 to LP$ (SPFF)

-if X0 is constant throughout life of SWAP then in each per. There would be diff. checks to LPFF - but there would be no settlement on the prin. at t=5  LPFF benefits since rFF > r$ and ER is constant.

Parallel and Back-to-Back Loans (PL +BBL)

-in 60s and 70s K controls existed which meant that firms were not free to X K from their domestic bases of operation.

-e.g. Br. firm could not raise debt K in Eng. + X proceeds.

-This is because of “...the belief that stopping overseas I was a way to require that Br. K be used for dom. I + thus to help create jobs for Br. Citizens.” (p.168)

BUT a co. Could lend proceeds to a domestic subsidiary (circumventing K controls) of a foreign firm. In ret. the domestically based subsidiary of the foreign firm would make PMTs in dom. curr. to the co. making the “loan”

-In this way cos would X K bypassing govt. reguls. – and also repatriate profits from for. I wo. paying taxes.

-This the concept of the PL

-The firms involved in the PL need not have any trade or bus. connecs, only “mutually compatible needs”

-A BBL arises when “fictional loans” are taken by subsidiaries of for. firms who then make PMTs to a dom. ‘parent’ co.

Drawbacks to PL + BBL which are alleviated via curr. swaps:

I). PL +BBL appear on the BS, while swaps are ‘off BS’  swaps make it appear that debt ratios are lower  easier to get credit - but they therefore encourage creation of debt  ↑S of bonds 

 PB  ↑ interest rates (r)  r are higher than they would otherwise be  EG

2). Diff. legal structures in diff. countries – which make legal obligs. unclear. - could be avoided by having banks intervene or intermediaries thereby assume counterparty risk.

-Banks acted as a ‘clearinghouse’ + lawyers were able ‘to conceive deals as exchanges of CFs (or swaps) instead of exchanges of loans...’ (p.171)

-thus swaps could be ‘off BS’ + CFs were viewed as ‘offsetting legs’ of a single trans.  banks became SWAP dealers + assumed counterparty default risk (C.W. Smith SACF Fall’94; Y.S. Park, J. of Intl. Bus. Studies Winter’84)

-this served to ctz. intl. mkt. and lower search costs

-CSDC thereby avoids need to have full amt. of funds (decreasing default risk) (M.Wood, Cross Currency Swaps, 1992)

-This was endorsed by Intl. Swap Dealers Assos. (ISDA) in 1985 using the term: bilateral closeout netting.

IBM – World Bank (WB) Swap

-1st actual curr. swap in 1981. WB wanted to raise K in SF but had already ‘saturated’ Swiss mkt.  higher credit risk for WB – while US mkt. viewed WB as a lower risk

-IBM feared SF app. + wanted to replace SF debt w. $ debt

-So Salomon Bros. Arranged a swap IBM recd. SF CFs while WB recd. $CFs IBM uses SFCFs to repay existing SF debt while WB uses $ CFs to repay $ debt.

IBM could convert SF debt into $ debt wo. retiring the SF debt while WB would raise funds at lower cost in US mkt.

Credit Risk Perceptions

-Irs in diff. mkts. have differing perceptions of the credit risk of cos./insts.

-US Irs may perceive the WB to be a lower credit risk than General Electric (GE) and Europeans may have the opp. view

-WB + GE will have lower fin. costs in their ‘preferred currencies’ if they issue debt in a for. curr., then engage in a FFCS, than if they issued ‘pref. curr.’ debt

 CCSW can prevail due to differential credit risk perceptions (this is similar to CA) + relative preferences for floating US fixed rate loans (also, diff. ER forecasts).

Swap–Driven Financing (SWDF)

SWDF  act of issuing debt (‘raising K’) then engaging in a SWAP

SWDF  cos. Can synthetically create either BC or debt or for. curr. debt (the latter is also accomplished via the CB app. above)

“ The role played by the intermediaries accelerated global interest in swaps - [showing] how priv. mkts were able to globalize, despite the capital controls”  mkts. are able to transcend govt. reguls.  govt. controls were futile + thus were removed  PZ and Thatcherism/Reaganism/Bushism!

Swap Innovations

-innov. From basic ‘plain vanilla swap’ (FFCS); annuity swap – aka. coupon–only swap  no prin. exchange at maturity (used for Hing amortizing Ls or for the interest portion of DCBs)

Zero-coupon swap- an exchg. of a single CF at a fut. date (same as a long-dated FWD) (for Hing prin. PMT of a DCB or PMT of a zero L)

Forward Swap – where there is a delay bet. the date on which the swap is contracted + the date of the first settlement

Swaptions – an option to originate as swap – used for callable debt (Brown + Smith, SACF, Winter 1990)

Mark-to-Market (MTM) Valuation of Currency Swaps

-value of a CS (VCS) = PMT that must be made by LP to assume swap pos. at that time

VCS < 0 if a PMT is nec. to initiate SP

(Gilbert, et al) J. Of Fixed Income, 3/93)

-VCS = 0 for an “at-mkt-swap”

-After CS is originated its value will  or ER s  need to know ER and DY curve for both currencies.

-E.g. the above 5yr, $1mil, 6% $ for 9% FF swap at X(FF/$)0 = 5. What is its value after 2nd int. PMT; DY for 1,2,3 yr euro$ is flat 6% while for euroFF it is flat 9%

 w. 3yrs left mkt. value = of $ PMTs $60,000/1.06 + $60,000/1.062 + $60,000/1.063+ $1mil/1.063 = $1mil

-t-value of FF PMTs = FF5mil (since DY = coupon rate  bonds issued at par)

-if X(FF/$) = 5 at this time  VCS = 0

-if X=6  FF5milCF = $833,333.33 VCS to LPFF =

-$166,667.67

-if LPFF wants to liquidate pos.  must find 3rd party to assume pos. To do so means that this 3rd party would receive the $166,666.67 to assume the pos.

-e.g. 6.4 shows that if FF were to app. than VCS >0 for LPFF must be paid by 3rd party if latter wants to assume the pos.

 MTM gain/loss on swap from pt. of view of LP is same % of NP as the % app/dep of the for. curr.

- int. rates also affects VCS; if t=2 FF r = 6.5% (1yr), 7%

(2yr) and 7.5% (3yr)  t=2 rFF < t=2 r$  value of FFPMTs

= FF5,202,617  if X=4  its $ PV = $1,300,654

 VCS = $1,300,654 - $1mil = $300,654  ↑ VCS due to app. of FF and lower t=2 rFF

Chd6 Appendix

Exchange Market Currency Swaps

EMCS  a spot trans. comb. w. a simul. opp. (offsetting) trans. in FWD mkt.

Swap rate – diff. bet. FWD ER + spot ER as a % of spot ER

e.g. if X($/£)0 = 2.00 + F($/£)1 = 2.05  (2.05 – 2.00)/2.00 = 0.05/2.00 = 2.5% - is 1yr ‘swap rate’  (F-X) x 100 = ‘swap points’

 (2.05 – 2.00) x 100 = 5 swap pts.

- Swap rate reps. A way to express int. rate diff. : if r$ - 12%  then via CARB  r£ = [2.00(1.12)/2.05 – 1] = 0.0927

- Swap rate links r$ + r£, since

r£ x swap rate = r$

 1.0927 x 1.025 = 1.12 = r$ “...the swap rate expresses (multiplicatively) the int. rate diff. bet. the two currs...” (p.187)

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