The two most basic types of Swaps are currency and interest rate swaps. A Swap is an agreement to exchange future cash flows on debt obligations. Commercial and investment banking firms have been trading in Swaps since the early 1980's.

 

A Curreny Swap is one where two parties agree to exchange currency payments at some point in the future at an agreed upon price.

 

Example:

   A British company (BCC) wants to expand in Canada. It borrows 50 Million British Pounds, with a payback period of 10 years, yield of 7% per annum, and coupon payments to be made semi-annually.

 

The other party (CAC) is a Canadian firm wanting to increase its presence in the UK. The Canadian company sells bonds in order to get 100 Million Canadian dollars with terms of 10 years, 6% paid semi-annually and maturing in 10 years.

 

BBC has British Pounds but wants to invest them in Canada. After investing, it will have revenues in Canadian dollars but will need to pay back its debt in British Pounds. BBC will convert its revenue dollars into pounds. Its debt payment will be equal to 500 Million * (0,07/2) = 17,5 Million pounds. These pounds will need to be bought on the open market, which then exposes BBC to exchange rate risk. To that, it will need to pay transaction costs.

 

On the other hand, the Canadian company will receive Canadian its revenue in Canadian dollars but will need to then convert the Canadian dollars into British pounds which expose it to exchange rate risk.  $100 Million * 0,06 / 2 = 3 Million Canadian dollars. Same as for BBC, CAC will need to pay transaction costs.

 

It would be feasible for the same dealer to act as intermediary for both transactions. Both sides would offer its currency (the bid price) and sell at the ask price. The dealer´s profits represents the delta between the two prices Add Price - Bid Price = Transaction Costs

 

If both companies enter into a swap, they can avoid the extra hassle of finding a dealer and having to pay transaction costs, by having each party agree to pay the debt of the other.

 

Essentially, each payment is a type of forward contract. A Swap agreement may be extended so that the companies also agree to pay off the principal in addition to the coupon payments. Swaps work best if they are short term and do not include interest payments. They are also achievable through banks, since banks have extensive products in a variety of markets and need to imediate offsetting swap before engaging in one.

 

Interest Rate Swaps

 

An interest rate swap involves exchange of debt obligations in the same currency. An example is a fixed rate traded for a floating rate coupon debt. As one can imagine, the debt has different terms. Interest rate swaps are more common than currency rate swaps.

 

Example:

 

Firm A has an outstanding bond with the following characteristics.

 

Face Value - 50 Million $

Interest Rate - 10% fixed rate

Intervals of Payments - every 6 months

Maturation - 2 years

Coupon Payments - 2,5 Million $

 

Firm B has debit with the following characteristics:

 

Face Value - 50 Million $

Interest Rate - floating rate + 2% (set on the day of turnover of the new period which is equal to 6 months) 

Current rate - 9% same as Treasury bill

Intervals of Payments - every 6 months

Maturation - 2 years

Coupon Payments - 2,5 Million $

Firm A would forward the money to Firm B to service B´s debt. Firm B would forward the money to Firm A to service A´s debt. Important to note, is that Firm B must pay 2,5 Million to Firm A no matter what happens to interest rates. But, in fact, Firm B has to pay only 0,25 Million dollars since that is the spread or difference between what it is obligated to pay A after deducting what it receives from A.

 

 

These types of swaps work best when two firms enter into an agreement with both having different credit ratings. The firm having the better credit rating would be more likely to receive a lower interest rate. Also important to note is that the spread of interest rates would be greater in a floating interest rate market than in a fixed interest rate market.

 

Of course there are always risks involved to the lenders. Interest rate swaps made in a floating rate market does not reward the lender for risk in terms of overall compensation. Instead, the lender may save money in terms of interest costs. Overall, in a floating rate swap, the interest rate for both parties is decreased.

 

Interest rate swaps made in fixed markets impose overall, more risk. This is because the risk of interest rate swaps in a fixed market is equal to the risk in a floating market less the risk in a fixed market.

 

A dealer may be involved, in which case, neither Firm benefits from the savings. All savings would go to the dealer. Or the firm having the better credit rating, arranges for a better deal with the trader.

Minicase

 

There exists two companies having different types of borrowing arrangements. One has terms for fixed interest rate and the other has a term expressed as floating interest rate.

 

The interest payments would look something like this.

 

Fixed:

   $2 million * 8.50% = $170,000

 

Floating:

   ($2 million 8 1%) + ($2 million * T-bill)

= $20,000 + ($2 million × T-bill rate)

 

Total interest paid by both:

   $170,000 + $20,000 + ($2 million × T-bill rate)

= $190,000 + ($2 million × T-bill rate)

 

What would be the affect on total interest paid, if both firms entered into an interest rate swap?

 

The firm with the fixed rate would pay at the floating rate, while the firm with the floating rate would pay at the fixed rate.

N borrows in the market for floating rates. P borrows in the market for fixed rates. They exchange rates and pay their debt as follows:

 

P

  $2 million * 6.50% = $130,000

 

N

   ($2 million / 2.25%) + ($2 million * T-bill rate)

= $45,000 + ($2 million * T-bill rate)

 

Total savings to both firms:

   $45,000 + $130,000 + ($2 million × T-bill rate)

= $175,000 + ($2 million * T-bill rate)

= $15,000 per year savings in interest or 0.75% (the net   

   quality differential)

 

In a real world setting, P had the higher credit rating which is why it received the lower interest rate. Remember that the quality spread also increases with a longer maturity period and in markets that serve fixed interest rates.

 

 

 

 

Every currency type has its own form or degree of risk. When parties agree to trade one form of another they can hedge their risk with the use of a currency swap.

 

Minicase

 

An American company wants to build a plant in Sweden to serve its European cutomers. The company needs to raise approximately 50  Million USD. The company expects to earn steady income, albeit, denominated in foreign currency, Swedish Krona [SEK], therefore; decides to issue bonds on the Swedish market in order to avoid the hassle of always making an exchange of currency, incurring transactions costs, all which expose it to foreign exchange risk. At this time, 1 US $ = 3,6463 SEK; therefore, the value of the credit line needing to be paid back is calculated to be 182,32 Million SEK.

 

An investment banker is called in to evaluate the risk of the company and help realize the bond issue. The investment banker determines that the company is not known very well in Sweden, therefore, has a higher level of risk. Since it is harder to raise funds in the Swedish market during the early start up phase of its operations, the investment banker determines an interest rate of 11% as appropriate. These funds could be raised more easily at home, therefore, the company decides to issue bonds at 8% in its home market.  After five years, the company should be well known in Sweden and can raise money with a lower interest rate than 11%.

 

The risk to the company is such that it has loan payments needing to be made in US dollars, but is serving that debt wtih revenues from a foreign country. Additional transaction costs will be incurred with the principal amount due at the end of the five years.

 

It would be financially costly for the company if the value of the US dollar were to strengthen against the SEK since more SEK would be needed to finance the debt. If the interest rate dropped, then less SEK would be needed to service the debt.

 

Calculations

 

Loan Terms

 

Credit:  50 Million $

Interest: 8%, annually

Maturity: 5 years

Coupon Payments

 

Coupon Payments: 50 * 0,08 * 3,6463 = 14,585,200 SEK

 

If the value of SEK were to strengthen to 4, then coupoun payments would equal: 50 * 0,08 * 4 = 16,000,000 SEK

 

1,414,800 additional SEK would be required in revenue to service it´s debt in US dollars.

 

Since management determines that the risk is that the SEK will be somewhere between 3,6463 and 4, the SEK required to fund its expansion lies somewhere between 182,315 and 200,000 million SEK (for the coupon payments alone, not yet considering the payback of the principal since it is too far in the future). In such as case, a hedge would be a way to reduce risk of foreign currency translation.

 

Five years is too long a time to use forwards and options since they are ideally suited to time frames in the short term. The investment banker finds another company with revenues in US dollars, but terms of credit in SEK.  A hedge agreement can cover both coupon payments and the principal amount.

 

The American company operating in Sweden agrees to pay the dealer the amount of its initial estimate of the coupon payments each year [SEK], plus an additional 50,000 SEK and 370,000 in the last year to manage the principal amount. In return, the American company will receive 4 Million $ per annum for five years to service its debt in the US.

 

At maturity, the dealer helps the American company again. The company pays 182,685,000 and receives 50 Million $. Cash savings may be had if interest rates do not rise. A company (the hedger) can deal directly with a dealer. Swap hedging involves large amounts of money and exists in an active market full of ready participants. This is especially true, as banks take on an ever increasing role in handling the trades.

 

Big banks add breadth and depth to the swap market because they disassemble the parts of debt and rework in into smaller parts, such as forwards and options. This is possible since banks are known to exploit market anomolies.