Work smart and think creative!!: Interest Rate and Foreign Currency Swaps

Basic purpose:

Allow firm to change the nature of their liabilities from fixed to floating interest rates or vise versa.
Currency swaps: allow firm to change the currency of denomination liabilities. An agreement between two parties to exchange the cash flows of two long-term bonds denominated in different currencies.
To seek out low-cost financing without sacrificing their preferred type of debt.
Credit default swap: was devised by JP Morgan bankers --> bilateral insurance contract between a protection buyer and a protection seller Why??

Due to subrime mortgage and financial crisis in the late 2000s, as the prevalence of increasing speculative investing and the sellers were in trouble.
Thanks to financial crisis, nowadays many countries considering to regulate this to protect against default on a specific bond or loan issued by a corporation or sovereign.

Swaps

Agreement between two counter-parties to exchange a sequence of cash flows or to exchange different types of debt.

maturities extend from 1 -30 years or more, structured like the cash flows of bonds.
Can be used to speculate.
Used to manage interest rate and currency risks.
Suggested best practices: International Swaps and Derivatives Association (ISDA) --> control legal aspects of swap cash flows.

Notional principal --> the amount of outstanding debt, the basic principal amount on which the cash flow of the interest rate swap depend.
Early form of swap: parallel loans and back-to-back loans.
Parallel loans:

simultaneous loans between multinational parent corporations in two different countries.
Contain the right to offset

Interest rate swaps

Allow MNC to change the nature of its debt from a fixed interest rate to floating interest rate or vice versa.
Fixed versus floating rate debt:

Many corporations have revenue cash flows that are pro-cyclical, which means their revenue are high during booms and low during recessions. And, short term interest rates are also pro-cyclical. That is, short-term interest rates tend to rise during expansions in the business cycle and fall during recessions.
This cyclical patterns increases the corporation's risk of default, as banks may prefer to enter into relatively long-term contracts to receive floating interest rate cash flows, but on the other hand, many investors prefer the certainty of long term, fixed interest debt.

Over, time, the firm's circumstances might be changed. For example: the firm's cash flow forecast is likely to be deteriorated at a time when long term interest rates are higher, thus the firm's might want to survive in its financial difficulties by swapping out its fixed-rate debt into a short-term debt with a lower interest rate.

Views of the future --> allow corporation to manage their interest rate risk or to speculate on the direction of interest rates and minimising the cost of debt.
Minimising the cost of debt --> In many cases, a large corporation determines their preferred kind of debt and the cheapest way to raise the funds, thus they uses the swap market to convert the actual debt into the desired debt. By doing so, the firms could minimise the cost of debt -- access counterpart's credit spread and change from fixed to floating (or vice versa)
Manipulating earnings --> "window dressing" swap activity

No exchange of principal is necessary because the principal is an equal amount of the same currency.
Nature of IR swaps contract:

commercial/investment bankers serve as market makers.
the bank's bid IR is the fixed rate that the bank is willing to pay for receiving semiannual payments corresponding to 6-month LIBOR.
the bank's ask IR is the fixed rate it will receive if the bank is willing to pay 6-month LIBOR.
Swap spread --> a number of basis points that are added to the yield to maturity on a US-government bond corresponding to that maturity.
Profits and risks for swap dealers --> as long as the bank matches the amount of IR swaps for a given maturity in which it will give and receive fixed interest rate payments, it will earn the bid-ask spread on that aggregate amount (if not, it has interest rate risk).
Dealing with credit risk -->

Even though interest rate swaps carry the right to offset, banks could also stop making its side of payment if the corporation defaults, and so the bank will widen its bid-offer spread in dealing with less creditworthy corporate.
Alternatively, bank may ask for credit enhancement in the form of collateral, which is what the International Swap and Derivative Association now recommends.

Foreign Currency Swaps

An agreement between two parties to exchange the Cash Flow of two long-term bonds denominated in different currencies.

Swaps the principal amount and interest rate.
Parties exchange initial principal amounts (at spot).
Parties pay interest on the currency they initially receive, receive interest on the currency they initially pay, and reverse the exchange of initial principal amounts at a fixed future date.

The mechanics of modern currency swaps --> transformation of both currency and the interest rate. For example:

Absolute borrowing advantage: in both currencies because its all-in costs are lower.
Comparative borrowing advantage: in one currency only, by issuing euro debt for example.

Using a financial intermediaries in a currency swap

Financial intermediaries would know of two counter parties that could benefits by swapping the interest and principal payments on bonds denominated in different currencies, they would arrange the swap, ast as counterpart, and walk away with a handsome profit.
Bank wants each firm to make the interest and principal payments in return for receiving cash flows that are equivalent to the interest and principal payments that each firm owes its bondholders.
The challenge is to make the swapping of these cash flows attractive to both counterparts. Also, bank bears the credit risk of each counterpart and it must be compensated for bearing this risk.

The rationale for currency swap

Low transaction cost instrument for changing the currency of denomination of debt financing.
Can issue bonds in any currency and swap into their desired currency at the lowest AIC.
Difference in spreads over risk-free rates --> provides an opportunity for lowering the cost of debt using swaps (market inefficiency) that can be exploited for profits.
Can issue debt in their least expensive currencies and to enter into a swap in their most preferred currencies.
Regulations on type of debt instruments and also accounting/tax differences.
Why use swaps and not forwards?

Work smart and think creative!!