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: 
• a means of securing low-cost funding for foreign subsidiaries.
• to circumvent various government regulations such as currency controls.
• avoid taxation of inter-company multinational transactions.
• Back-to-back loans:
• simultaneous loans between multinational parent corporations in two different countries.
• Contain the right to offset

Interest rate swaps

• Why use 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.
• Changed circumstances: 
• 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:
• USD: 5.25% bid and 5.35% offered against 6-month dollar LIBOR.
• GBP: 8.00% bid and 8.10% offered against 6-month dollar LIBOR.
• 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?
• Long-dated forward markets are illiquid.
• Associated cash flows of swaps are just like bonds.

Real Exchange Risk

Definition: the phenomenon whereby the profitability of a firm can change because of fluctuations in the real exchange rate. (= operating exposure or economic exposure)

Value of a firm is represented by the present value of its expected future profitability, thus could affect a firm's cash flows, either through changes in demand or costs.

Pricing to market: producer charges different prices for the same good in different markets.

Depreciation of local currency: hurts net importer but benefits net exporter.

Strategies for managing real exchange risk: 

• Production scheduling: use changes in inventory to meet firm's transitory fluctuations in demand.
• Input sourcing: when domestic currency is strong, domestic firms should use foreign inputs.
• Plant locations: shifting production among existing locations (firm should increase production in countries whose depreciated in currency)
• Pricing policies: when a currency depreciates, exporter to that country face a trade off (profits vs market share). If firm increase price -- they will lose market share, but if the product is inelastic, the exporter could increase its prices by a greater amount.
• The frequency of price adjustment: consumer hates it, thus company should build boundaries that will not trigger a change in price.
• Market entry decision: introducing new product in foreign markets when the foreign currencies are strong -- set up a comparatively low price for product.
• Brand loyalty -- consumer hardly to switch to other competitor's product.

The fisher hypothesis: nominal interest rates should reflect expectations of the rate of inflation. Real rates of return - measures how much your purchasing power has increased over time.

Fundamental exchange rate forecasting: econometric models (money supply, inflation, productivity, growth rates); judgment of future macroeconomic relationships; concerned with multiyear forecasts.

Technical analysis: short term forecasts; using historical data to find pattern; information about the future exchange rate is assumed to be present in past trading behaviour.

The asset market approach: the exchange rate as an asset price, just like stocks -- based on current and future cash flows; fluctuate randomly by people's willingness to hold this particular currencies; the exchange rate as a weighted average of current fundamental and its expected future values; changes as news come out or good/bad expectations.

The monetary approach: real money balance; concerned with the real value of the nominal money; function of money supplies and income levels in two countries; supply money in domestic currency increases--weaken in domestic currency; supply money in foreign currency increases--domestic strengthen; if domestic real income falls--the foreign income rises; or news expected lower domestic growth or faster foreign growth--domestic currency weakens.

Balance of Payments (BOP) = Current Account (export and import) + Capital Account (foreign investment inflows and outflows) + central bank's reserve account = 0
Ex: strong domestic currencies -- foreign goods cheaper -- increase of imports relative to exports -- current account deficit.
Higher interest rates -- increase savings and decrease real investment -- capital account deficit (losing net foreign investment).
Equilibrium: supply and demand force an equilibrium price and quantity of the real exchange rate on the current account through a "goods" channel and a "savings and investment" channel.

Potential spurious pattern: chartist rely on graphs to detect trends rather than on statistics.

Filter rules: provide signals on investors as to when to buy and sell currencies.
x% rules -- buy the currencies if it appreciates by x% above its support level and sell the currencies when it falls x% below its resistance level.
moving average cross-over rules: the average value of an exchange rate over a set of period. Buy (go long)-- short term (y days) moving average crosses the long-term (z days) moving average from below. Sell (go short) if it crosses from above. But, simple moving average rules works better.

Ex-post: correct the nominal interest rate with the realised or ex post rate of inflation; Ex-ante: correct the nominal interest rate with expected inflation.

Higher nominal interest rate -- higher expected rate of inflation -- country's currency expected to depreciate relative to dollar -- trade in forward discount relative to dollar.

Large increase in domestic money supply -- a depreciation of the currency. But it could be offset the money supply effect, if an increase in real income that increase the demand for money.

An increase in government spending or a decrease in taxes that causes a budget deficit should increase the real exchange rate -- increase aggregate demand which causes the real interest rates to rise.

Interest Rate Parity

Covered interest rate parity -- doesn't matter where you invest -- you'll have the same domestic currency return as long as the foreign exchange risk is covered using a forward contract.

Uncovered interest rate parity -- domestic and foreign investments have same expected returns.

Unbiasedness hypothesis -- no systematic differences between the forward rate and the expected future spot rate. If hypothesis holds, the expected return on currency speculation will be exactly zero.

Forecast error -- the differences between the actual future spot exchange rate and its forecast.

Unbiased predictors -- implies expected forecast error = 0

Market inefficiency -- interest rate differentials contain information from which profit can be obtained; exploiting forward bias and carry trades (represents the interest rate differentials between the high and the low yield currencies, i.e.: borrowing low interest rate currencies and lending high interest rate currencies). If the high interest rate currency fails to depreciate as much as the interest rate differential, the carry forward has a positive return.

Sharpe ratio: excess return per unit of risk; a measure of the risk trade-off on an asset or a portfolio of assets; the ratio of average asset return / the standard deviation.