Chapter

QUESTIONS

21

Interest Rate and Foreign Currency Swaps

1. How does an interest rate swap work? In particular, what is the notional principal? Answer: An interest rate swap is an agreement between counterparties that allows an MNC to change the nature of its debt from a fixed interest rate to a floating interest rate or from a floating interest rate to a fixed interest rate. One counterparty to the basic interest rate swap pays a fixed amount of interest on a notional principal to the other counterparty, which in turn is paying the floating interest rate cash flows on the same notional amount to the first counterparty. The term notional indicates the basic principal amount on which the cash flows of the interest rate swap depend. Unlike a currency swap, no exchange of principal is necessary because the principal is an equal amount of the same currency. Usually, only a net interest payment is made depending upon whether the fixed interest rate stated in the swap is higher or lower than the floating interest rate. 2. What is a currency swap? Describe the structure of and rationale for its cash flows. Answer: A currency swap is essentially an agreement between two parties to exchange the cash flows of two long-term bonds denominated in different currencies. The parties exchange initial principal amounts in the two currencies that are equivalent in value when evaluated at the spot exchange rate. Simultaneously, the parties agree to pay interest on the currency they initially receive, to receive interest on the currency they initially pay, and to reverse the exchange of principal amounts at a fixed future date. 3. What is a credit default swap? What happens in the event of default? Answer: A credit default swap is essentially a bilateral insurance contract between a protection buyer and a protection seller to protect against default on a specific bond or loan issued by a corporation or sovereign (the reference entity). The protection buyer pays semi-annual or annual insurance premiums to the protection seller. In return, when there is a default event, the protection seller transfers value to the protection buyer. Value is transferred either through physical settlement or cash settlement. If there is physical settlement, the protection buyer delivers the defaulted bond to the protection seller who pays the face amount of the referenced bond. If there is cash settlement, the protection seller pays the buyer the difference between the face value of the bond and the value of the defaulted bond. 4. Banks quote interest rate and currency swaps using the 6-month LIBOR as a basis for both transactions. How can a bank make money if it does not speculate on movements in either interest rates or exchange rates?

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Chapter 21: Interest Rate and Foreign Currency Swaps

Answer: Banks quote the fixed side of the swap with a bid-ask spread. When they pay the fixed-rate side of the swap, they do so at a lower rate than when they receive the fixed-rate side of the swap from their counterparty. Thus, if they are able to balance the transactions, being both a payer of the fixed rate and a receiver of the fixed rate for the same gross amounts, they earn the bid-ask spread. This can be a substantial amount of money. 5. What is the AIC of a bond issue? Answer: The all-in cost (AIC) of a bond issue is the internal rate of return that equates the present value of all the future interest and principal payments to the net proceeds (face value minus fees) received by the issuer. 6. What is a comparative advantage in borrowing, and how could it arise? Answer: Comparative advantage in borrowing means that the ratio of the borrowing cost in one currency (one plus the interest rate) to the borrowing costs in another currency is not the same for two companies. The company with the lower ratio has a comparative advantage in borrowing the numerator currency even though its absolute borrowing costs may be higher than the other companys costs in each currency. Such differences imply that the companies should borrow in the currency in which they have a comparative advantage, and swap into the currency of choice based on other considerations such as foreign exchange risk. Comparative borrowing advantages arise because institutional differences across countries lead to debt pricing that is slightly different, depending on the ultimate holder of the debt and its currency of denomination. Some of these pricing differences are due to the different ways credit risks are analyzed around the world. Essentially, these differences amount to a market inefficiency that can be exploited for profit. The result is that some companies can more easily issue debt in some currencies than in other currencies. 7. What is basis point adjustment? Why is it not appropriate simply to add the basis point differential associated with the first currency to the quoted swap rate that the firm will pay? Answer: If a customer wants the financial intermediary to do a currency swap in which the financial intermediary will pay the interest and principal on the customers outstanding bond, which has an interest rate that is different from the interest rate that the intermediary is quoting, the financial intermediary will also have to adjust the basis points on the cash flows of the currency in the swap that the customer is paying. One cannot simply add the additional basis points that the financial intermediary is paying to the rate that the customer will pay, if the levels of the interest rates on the two currencies are different, because a basis point in the future for a currency that is depreciating in value is worth less than a basis point in the future for a currency that is appreciating in value. The correct procedure requires that one take the present value of the extra interest rate payments that the financial intermediary is paying in one currency, convert that amount into the currency that the customer is paying with the spot exchange rate, and determine the additional level payments of the new currency that would have that present value. 8. Discuss the sense in which a 5-year currency swap is a sequence of long-term forward contracts. How do the implicit forward exchange rates in a currency swap differ from the long-term

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Chapter 21: Interest Rate and Foreign Currency Swaps

forward exchange rates for those maturities? Answer: A 5-year currency swap is an agreement to exchange certain amounts of two currencies in the future, which sounds very similar to a forward contract. Unlike forward contracts, though, the amounts are the same for the first four years, equal to the interest on the principals of the two currencies. Then, in the fifth year, the interest and principals on the two currencies are exchanged. The principals were originally equal in value at the original spot exchange rate, but they will generally not be equal in value at the final spot exchange rate. 9. What are the determinants of the value of a currency swap as time evolves? Is it possible to close out a swap before it has reached maturity? Answer: When a swap is initiated, the cash flows of two bonds in different currencies are agreed to be exchanged. These bond-like cash flows have the same present value at the current spot exchange rate. Changes in the exchange rate obviously change the value of one side of the swap compared to the value of the other side of the swap. In addition, increases in interest rates decrease the present value of cash flows, and decreases in interest rates increase the present value of cash flows. Thus, changes in interest rates and exchange rates give currency swaps value. One side wins and the other loses. It is possible to close out a swap by having the party that has lost money in the swap pay this value to the party that has gained value in the swap.

PROBLEMS
1. General Motors (GM) wants to swap out of $15,000,000 of fixed interest rate debt and into floating interest rate debt for 3 years. Suppose the fixed interest rate is 8.625% and the floating rate is dollar LIBOR. What semiannual interest payments will GM receive, and what will GM pay in return? Answer: Because General Motors wants to swap out of the fixed interest rate debt into a floating interest rate debt, it will receive the fixed interest rate side of the swap, and it would pay the semiannual LIBOR. Thus, it would receive 6 semiannual payments of 0.5 0.08625 $15 million = $646,875 These payments would be fixed for 5 years. Financial Institution Pays the Receives the Floating Fixed Rate Rate ($646,875) LIBOR/2 x $ 15 mill ($646,875) LIBOR/2 x $ 15 mill ($646,875) LIBOR/2 x $ 15 mill ($646,875) LIBOR/2 x $ 15 mill ($646,875) LIBOR/2 x $ 15 mill ($646,875) LIBOR/2 x $ 15 mill General Motors Receives the Pays the Floating Rate Fixed Rate $646,875 (LIBOR/2 x $ 15 mill) $646,875 (LIBOR/2 x $ 15 mill) $646,875 (LIBOR/2 x $ 15 mill) $646,875 (LIBOR/2 x $ 15 mill) $646,875 (LIBOR/2 x $ 15 mill) $646,875 (LIBOR/2 x $ 15 mill)

Time Period Year 0.5 Year 1.0 Year 1.5 Year 2.0 Year 2.5 Year 3.0

Because the currency is the same, only a net interest payment is actually transferred between the two parties. That is, the party with the higher interest rate pays the net interest payment to the party with the lower interest rate.

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Chapter 21: Interest Rate and Foreign Currency Swaps

2. Pfizer is a U.S. firm with considerable euro assets. It is considering entering into a currency swap involving $10 million of its dollar debt for an equivalent amount of euro debt. Suppose the maturity of the swap is 8 years, and the interest rate on Pfizers outstanding 8-year dollar debt is 11%. The interest rate on the euro debt is 9%. The current spot exchange rate is $1.35/. How could a swap be structured? Answer: Pfizer wants to swap out of $10 million of dollar debt that has an 11% interest rate and to swap into an equivalent amount of euro-denominated debt that will require payments of 9% per annum. At the spot exchange rate of $1.35/, the $10 million is equivalent to

$10,000,000 = 7,407,407.41 $1.35/

Thus, at the beginning of the swap, Pfizer would transfer $10,000,000 to the financial intermediary, and Pfizer would receive 7,407,407.41. If interest is paid semi-annually, Pfizer would receive

0.5 ? 0.11 ? $10,000,000 = $550,000

every 6 months for 8 years. Pfizer would have to pay

0.5 ? 0.09 ? 7,407,407.41 = 333, 333.33

After 8 years, the original principals would also be exchanged. Pfizer would receive $10,000,000 from the financial intermediary, and Pfizer would pay 7,407,407.41 to the financial intermediary. 3. At the 7-year maturity, the market sets the price of U.S. Treasury bonds to have a yield to maturity of 7.95% p.a. The Second Bank of Chicago states that it will make fixed interest rate payments on dollars at the yield on Treasury bonds plus 55 basis points in exchange for receiving dollar LIBOR, and it will receive fixed interest rate payments on dollars at the yield on Treasury bonds plus 60 basis points in exchange for paying dollar LIBOR. If you enter into an interest rate swap of $10 million with Second Chicago, what will be your cash flows if you are paying the fixed rate and receiving the floating rate? Answer: You pay the higher rate to the bank, so you would pay fixed interest at 7.95% + 0.60% = 8.55% You would receive interest at LIBOR. This way, the bank pays fixed interest at 5 basis points less than it receives interest. Your actual cash flows would be determined by the relationship between LIBOR and the 8.55% fixed interest rate. If LIBOR > 8.55%, each 6 months you would receive the net amount 0.5 (LIBOR 8.55%) $10 million If LIBOR < 8.55%, you would pay the net amount 0.5 (8.55% - LIBOR) $10 million 4. The swap desk at UBS is quoting the following rates on 5-year swaps versus 6 month dollar LIBOR: U.S. dollars: 8.75% bid and 8.85% offered Swiss francs: 5.25% bid and 5.35% offered You would like to swap out of Swiss franc debt with a principal of CHF25,000,000 and into fixed-rate dollar debt. At what rates will UBS handle the transaction? If the current exchange rate is CHF1.3/$, what would the cash flows be?

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Chapter 21: Interest Rate and Foreign Currency Swaps

Answer: Because you want to swap out of Swiss franc debt, you want UBS to pay you Swiss francs and you want to pay UBS dollars. UBS pays Swiss francs at 5.25%, and it receives dollars at 8.85%. When you receive Swiss francs, you pay 6-month dollar LIBOR on the equivalent dollar amount, and when you pay dollars, you receive 6-month dollar LIBOR on that same dollar amount. Thus, the floating rate dollar cash flows cancel, and you would just make the fixed rate dollar payment and would receive the fixed rate Swiss franc payment. In the beginning of the currency swap, you would give the Swiss franc principal of CHF25,000,000 to UBS who would give you

CHF25,000,000 = $19,230,769 CHF1.3/$

You would then make semi-annual dollar payments of 0.5 8.85% $19,230,769 = $850,962 You would receive semi-annual Swiss franc payments of 0.5 5.25% CHF25,000,000 = CHF656,250 At the end of 5 years, you would also pay the principal of $19,230,769 and you would receive the CHF25,000,000. 5. Suppose Viacom can issue $100,000,000 of debt at an AIC of 9.42%, whereas Gaz de France can issue $100,000,000 of debt at an AIC of 10.11%. Suppose that the exchange rate is $1.35/. If Viacom issues euro-denominated bonds equivalent to $100,000,000, its AIC will be 8.27%, whereas if Gaz de France issues such bonds, its AIC will be 9.17%. Which firm has a comparative advantage when borrowing euros? Why? Answer: Clearly, Viacom borrows at a lower rate than Gaz de France in both dollars (9.42% vs. 10.11%) and euros (8.27% vs. 9.17%). Viacom therefore has an absolute borrowing advantage in each currency. It is a better credit risk. To assess the comparative advantage, we must take the ratio of the borrowing costs. Viacoms ratio of euro cost to dollar cost is 1.0827 / 1.0942 = 0.9895. Gaz de Frances ratio of euro cost to dollar cost is 1.0917 / 1.1011 = 0.9915. Because Viacom has the lower ratio of euro cost to dollar cost, Viacom has a comparative advantage in borrowing euros. 6. Suppose in problem 5 that because of currency risk, Viacom would prefer to have dollar debt, and Gaz de France would prefer to have euro debt. How could an investment bank structure a currency swap that would allow each of the firms to issue bonds denominated in the currency in which the firm has a comparative advantage while respecting the firms preferences about currency risks? Answer: Because Viacom has a comparative advantage in borrowing euros, it should borrow euros and swap into dollars. Gaz de France should do the opposite, that is, borrow dollars and swap into euros. An investment bank could have Viacom issue a euro bond and have Gaz de France issue a dollar bond. Each firm would make the other firms interest and principal payments. The initial principals that are raised could then be adjusted so that the all-in-cost on the dollar cash flows of Viacom is lower than Viacoms direct dollar borrowing cost, while the all-in-cost on the euro cash flows of Gaz de France is lower than Gaz de Frances direct euro borrowing cost. The investment bank that arranged this deal would actually be able to keep some of the principal amounts for arranging the deals.

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Chapter 21: Interest Rate and Foreign Currency Swaps

7. Suppose Sony issues $100,000,000 of 5-year dollar bonds. Nomura will handle the bond issue for a fee of 1.875%. Sonys bonds will be priced at par if they carry a coupon of 8.5%. As the swap trader for Mitsubishi UFJ (MUFJ), you have been quoting the following rates on 5-year swaps: U.S. dollars: Japanese yen: 8.00% bid and 8.10% offered against the 6-month dollar LIBOR 4.50% bid and 4.60% offered against the 6-month dollar LIBOR

Sony would like to do the dollar bond issue, but it prefers to have fixed-rate yen debt. If MUFJ gets the proceeds of the dollar bond issue, giving Sony an equivalent amount of yen, and MUFJ agrees to make the dollar interest payments associated with Sonys dollar bonds, what yen interest payments should MUFJ charge Sony? What is Sonys all-in cost in yen? The current spot exchange rate is 98.50/$. Answer: The following exhibit provides the analysis, which is explained below.
Sony's Dollar Bond Issue and Cash Flows in the Swap into Yen with MUFJ (All cash flows are in millions of dollars or yen) Dollar Bond Issue Year 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 AIC Annual AIC Swap Receipts (+) and Payment (-) with MUFJ notional $ dollars notional -100.00 -98.13 9,850.00 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 4.00 4.25 -226.55 104.00 104.25 -10,076.55 4.00% 4.49% 2.30% 8.16% 9.17% 4.65% extra dollar interest 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 extra yen interest 22.59 22.59 22.59 22.59 22.59 22.59 22.59 22.59 22.59 22.59 Effective yen cash flows 9,665.31 -249.14 -249.14 -249.14 -249.14 -249.14 -249.14 -249.14 -249.14 -249.14 -10,099.14 2.75% 5.57%

98.13 -4.25 -4.25 -4.25 -4.25 -4.25 -4.25 -4.25 -4.25 -4.25 -104.25 4.49% 9.17%

Note: The present value at 4.00% of the 10 extra interest payment of $0.25 million is $2.03 million. This is equivalent to 199.73 million yen at the current exchange rate. The present value at 2.30% of 10 extra interest payment of 22.59 million yen is 199.73 million yen. The annual AIC calculations compound the semi-annual rates, e.g. (1.0449^2) = 1.0917.

The first thing to determine is the dollar proceeds of the bond issue. Because it is priced at par, Sony will receive 1.875% less than the $100 million provided by investors: $100,000,000 (1 0.01875) = $98,125,000 This amount will be given to MUFJ in exchange for an equal amount of yen: $98,125,000 98.50/$ = 9,665,312,500 To determine the interest payments, we must examine what MUFJ is quoting. When MUFJ does a 5-year swap and pays $100 million of principal, it expects to pay interest at 8% or 4% semi-annually. Sony wants it to pay the interest on its outstanding bond, which has a semi-annual coupon of 8.5%. Thus, there is an extra $0.25 million of interest every half year for 5 years. This amount is given in the column labeled extra dollar interest.

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Chapter 21: Interest Rate and Foreign Currency Swaps

The yen principal that is associated with $100 million at the current exchange rate of 98.50/$ is $100,000,000 98.50/$ = 9,850,000,000 MUFJ would normally receive interest on this amount at 4.6% from Sony, which would be 226.55 million every half year, but we must increase the yen interest to reflect the increase in dollar interest that MUFJ is paying. In the absence of spot interest rates for each maturity, we can take the present value of the extra dollar interest at 8%. This amount is $2.03 million. The yen value of this dollar amount at the current exchange rate is 199.03 million. The sequence of 10 semi-annual payments that is equivalent to 199.03 million is 22.59 million. We must add this interest to the 226.55 million to get the full interest that Sony will pay. Thus, Sony receives 9,665,312,500 in the beginning of the swap, pays semi-annual interest of 249.14 million for 5 years, and pays the principal amount of 9,850,000,000 in year 5. The all-in-cost of this yen loan is 5.57%. Notice that 5.57% is only 92 basis points above the all-in cost of the quoted yen interest rate in the swap, whereas the original dollar bond is 101 basis points above the all-in cost of the quoted dollar interest rate. Increasing the cost of the yen loan by 101 basis points would have over-charged Sony because a yen basis point in the future is worth more than a dollar basis point in the future because the yen is strengthening relative to the dollar. 8. Assume that 1 year has passed since you entered into the transaction described in problem 4. Assume that the new spot exchange rate is CHF1.45/$ and that UBS is now quoting the following interest rates on 4-year swaps: U.S. dollars: 7.50% bid and 7.60% offered against the 6-month dollar LIBOR Swiss francs: 6.75% bid and 6.85% offered against the 6-month dollar LIBOR If you close out the swap transaction of problem 4, what net dollar cash flow will you experience? Explain why this is the correct amount. You can assume that the term structures of interest rates in both currencies are flat. Answer: You owe eight additional semi-annual payments of $850,962 and a final principal payment of $19,230,769. The present value of these cash flows at 3.80% = 7.60%/2 is $20,046,721. At the current exchange rate of CHF1.45/$, this Swiss franc value of the dollar present value is

CHF1.45 ? $20,046,721 = CHF29,067,746 $

You are also scheduled to receive eight additional semi-annual payments of CHF656,250 and a final principal payment of CHF25,000,000. The present value of these cash flows at 3.375% = 6.75%/2 is CHF23,704,383. Thus, you can close out the swap if you make a net payment of CHF29,067,746 CHF23,704,383 = CHF5,363,363 You have to pay to close out the swap because the interest rate on dollars, which is what you are paying, has fallen; the interest rate on Swiss francs, which is what you are receiving, has risen; and the dollar has weakened relative to the Swiss franc. Each of these changes causes the swap to decrease in value from your perspective. 9. Web Question: Go to www22.verizon.com/investor/app_resources/interactiveannual/2010/ mda06.html to find an excerpt of the 2010 Annual Report of Verizon, a large telecommunications company. Determine whether they use interest rate and/or currency swaps and why. Answer: This is what the web site states about interest rate risk and the use of interest rate swaps and

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Chapter 21: Interest Rate and Foreign Currency Swaps

currency swaps:
Interest Rate Risk We are exposed to changes in interest rates, primarily on our short-term debt and the portion of longterm debt that carries floating interest rates. As of December 31, 2010, more than three-fourths in aggregate principal amount of our total debt portfolio consisted of fixed rate indebtedness, including the effect of interest rate swap agreements designated as hedges. The impact of a 100 basis point change in interest rates affecting our floating rate debt would result in a change in annual interest expense, including our interest rate swap agreements that are designated as hedges, of approximately $0.1 billion. The interest rates on our existing long-term debt obligations are unaffected by changes to our credit ratings. The table that follows summarizes the fair values of our long-term debt, including current maturities, and interest rate swap derivatives as of December 31, 2010 and 2009. The table also provides a sensitivity analysis of the estimated fair values of these financial instruments assuming 100-basispoint upward and downward shifts in the yield curve. Our sensitivity analysis does not include the fair values of our commercial paper and bank loans, if any, because they are not significantly affected by changes in market interest rates.
(dollars in millions)

Fair Value assumin g +100 Fair At December 31, 2009 Values basis point shift

Fair Value assumin g 100 basis point shift

Long-term debt and related derivatives At December 31, 2008 Long-term debt and related derivatives

58,59 55,42 62,24 1 $ 7 $ 7

$ 66,042 $ 62,788 $ 69,801

Interest Rate Swaps We have entered into domestic interest rate swaps to achieve a targeted mix of fixed and variable rate debt, where we principally receive fixed rates and pay variable rates based on London Interbank Offered Rate. These swaps are designated as fair value hedges and hedge against changes in the fair value of our debt portfolio. We record the interest rate swaps at fair value on our consolidated balance sheets as assets and liabilities. Changes in the fair value of the interest rate swaps are recorded to Interest expense, which are offset by changes in the fair value of the debt due to changes in interest rates. The fair value of these contracts was $0.3 billion and $0.2 billion at December 31, 2010 and December 31, 2009, respectively, and are primarily included in Other assets and Long-term debt. As of December 31, 2010, the total notional amount of these interest rate swaps was $6.0 billion. During February 2011, we entered into interest rate swaps, designated as fair value hedges, with a notional amount of approximately $3.0 billion. Cross Currency Swaps Verizon Wireless has entered into cross currency swaps designated as cash flow hedges to exchange approximately $2.4 billion British Pound Sterling and Euro denominated debt into U.S. dollars and to

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Chapter 21: Interest Rate and Foreign Currency Swaps

fix our future interest and principal payments in U.S. dollars, as well as mitigate the impact of foreign currency transaction gains or losses. The fair value of these swaps included primarily in Other assets was approximately $0.1 billion and $0.3 billion at December 31, 2010 and December 31, 2009, respectively. During 2010 and 2009, a pre-tax loss of $0.2 billion, and a pre-tax gain of $0.3 billion, respectively, was recognized in Other comprehensive income, a portion of which was reclassified to Other income and (expense), net to offset the related pre-tax foreign currency transaction gain on the underlying debt obligations.

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