Introduced by Assoc. Pr. Dr. Truong Quang Thong The Faculty of Banking – UEH August 2012 INTERNATIONAL FINANCE TÀI CHÍNH QUỐC TẾ Lecture 7: Interest Rate and Currency Swaps 1 Overview  Defining interest rate risk.  Examining its management including credit risk and repricing risk.  Illustrating floating rate loan case and expalining how it can be managed with forward rate agreement, interest future and interest rate swap.  Introducing currency swap case 2 Interest rate risk  All firms are sensitive to interest rate movements in one way to another.  Debt structure of large firms are very complicated:  Different maturities  Different interest rate structures  Different currencies of denomination  Holding of interest-sensitive securities  Marketable securities porfolio on the left-hand side of the BS.  Representing potential earnings or interest inflows 3 The Management Dilemma  The balance of risk and return  The role of treasury:  Cost center?  Profit center? 4 Credit Risk and Repricing Risk  Credit risk or roll-over risk, is the possibility that a borrower’s credit worthiness, at the time of renewing a credit, is reclassified by the lender.  Repricing risk: is the risk of changes in interest rates charged (earned) at the time a financial contract ‘s rate is reset. 5 An example of debt strategies – The same intention to provide $1 million in financing for 3 year period  Strategy 1: borrow $1 million for 3 years at a fixed rate of interest.  Strategy 2: borrow $1 million for 3 years at floating rate, LIBOR+2%, to be reset annually.  Strategy 3: borrow $1 million for 1 year at fixed rate, then renew the credit annually. 6 7 Loan interest rate Year 0 Year 1 Year 2 Year 3 Libor (floating) 5.00% 5.00% 5.00% 5.00% Spread (Fixed) 1.50% 1.50% 1.50% Total interest payable 6.50% 6.50% 6.50% Interest CFs on Loan Libor (floating) (500.000) (500.000) (500.000) Spread (Fixed) (150.000) (150.000) (150.000) Total interest (650.000) (650.000) (650.000) Loan proceeds (Repayment) 9.850.000 (10.000.000) Total Loan Cash Flows 9.850.000 (650.000) (650.000) (10.650.000) IRR of Total Cash Flows 7.072% (AIC) Sensitivities to Libor Libor (Y0) Libor (Y1) Libor (Y2) Libor (Y3) AIC Baseline case above 5.00% 5.00% 5.00% 5.00% 7.072% Libor rises 25bp / year 5.25% 5.50% 5.75% 7.565% Libor falls 25bp/ year 4.75% 4.50% 4.25% 6.578% Carlton’s Floating Rate Case – Loan of $10 millions with 1.5% up-front fee. Annual interest payment. Total principal repayment at the end of 3 year period 8 Management Alternatives  Refinancing  Forward Rate Agreement (FRA)  Interest Rate Future  Interest Rate Swaps 9 Forward rate agreement (FRA)  FRA is an interbank-traded contract to buy or sell interest rate payment on a notional principal.  The buyer obtains the right to lock in an interest rate for a desired term that begins at a future date  The seller will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the the agreed rate, and vice versa… 10 Example  The borrower wishes to lock in the first interest payment (due at the end of year 1): buy an FRA that locks in a total interest payment of 6.5%.  If LIBOR rises above 5% by the end of year 1 ?  If LIBOR falls below 5% ? [...]... interest rate payment for the floating interest rate payments of another: interest swap  If to swap currencies of debt service obligation: currency swap  A single swap may combine element of both interest rate and currency swaps  Plain Vanilla Swap: agreement between tow parties to exchange fixed for floating rate financial obligation Interest Rate Swap Strategies Position Exppectation Strategy Fixed rate. .. floating -rate interest payment due in March 2003  sell a future  So, locking in an interest rate of 5.24%  If interest rate rise by Marche 2003?  If interest rate fall by Marche 2003? Interest Rate Futures Strategies for Common Exposures Exposure or Position Paying interest on future date Futures Actions Interest Rate Sell a future (Short position) If rates go up If rates go down Earning interest. .. rates go up If rates go down Position Outcome Future price fall; short earns a profit Future price rises; short earns a loss Future price fall; long earns a loss Future price rises; long earns a profit Interest Rate Swaps  Swaps are contractual agreements to exchange or swap a series of cash flows commonly including interest and debt service, such as the floating rate loan  If to swap its fixed interest. .. Spread (fixed) Total interest payable SWAP INTEREST RATE Pay fixed Receive floating Libor COMBINED LOAN AND SWAP POSITION LIBOR ON LOAN Paying -5.00% -5.00% -5.00% Spread (fixed) Paying -1.50% -1.50% -1.50% Pay fixed on swap Paying -5.75% -5.75% -5.75% Receiving +5.00% +5.00% +5.00% Net payment -7.25% -7.25% -7.25% Receiving floating Libor on swap Net interest due after swap Currency Swap  Motivation:... be rising in three years ahead  It believes that a pay fixed/receive floating interest swap may be a better alternative for fixing future interest rate now  It is quoted by a bank a fixed rate of 5.75% against Libor Is this a good deal for Carlton? Carlton’s Interest rate swap to pay fixed / receive floating Loan interest rate LIBOR (floating)) Variability Year 1 Year 2 Year 3 Could go up or down -5.00%... financial obligation Interest Rate Swap Strategies Position Exppectation Strategy Fixed rate debt Rates to go up Do nothing Rates to go down Pay floating/Receive fixed Rates to go up Pay fixed/Receive floating Rates to go down Do nothing Floating rate debt Interest Rate Swaps - Example  Carlton ‘s existing floating rate loan is now the source of some concerns (loan of $10 millions at Libor+2%)  It worries... Net interest due after swap Currency Swap  Motivation: to replace cash flows scheduled in an undesired currency with flows in a desired currency  Utility is significant for MNSC Currency Swap - Example  After raising $10 million in floating rate financing and subsequently swapping into fixed rate payments, Carlton decides that it would prefer to make its debt service payment in Swiss francs  Carlton... three year period  It wishes to match the currency of denomination of the cash flows through a currency swap Pay Swiss Francs and Receive US Dollars SWAP component Year 0 on a notional principal of Cash Flow Carlton will pay 5,56% 5,56% 556.000USD 556.000USD 10.556.000USD 2,01% 2,01% 2,01% 301.500CHF 301.500CHF 15.301.500CHF CHF1,50/USD Will pay fixed CHF at rate: On a notional principal of Year 3 10.000.000USD... Will pay fixed CHF at rate: On a notional principal of Year 3 10.000.000USD Cash Flow received Exchange rate Year 2 5,56% Will receive fixed US$ at this rate Year 1 15.000.000CHF Observation  At the time of the Swap s inception  Gain or loss throughout the Swap s life  Nonamortizing Swap vs Unwinding Swap .. .Interest Rate Future  Relatively widely used by high liquidity, simplicty in use  The two most widely used future contracts:  Eurodollar futures traded on the CME  US Treasury Bond Futures of CBOT Example: Typical presentation by the WSJ Only regular quartely matutities are shown All contracts are for $1 million Points of 100% Open interest is number of contracts outstanding Eurodollar . 2012 INTERNATIONAL FINANCE TÀI CHÍNH QUỐC TẾ Lecture 7: Interest Rate and Currency Swaps 1 Overview  Defining interest rate risk.  Examining its management including credit risk and repricing risk.  Illustrating. risk.  Illustrating floating rate loan case and expalining how it can be managed with forward rate agreement, interest future and interest rate swap.  Introducing currency swap case 2 Interest rate risk  All. floating rate loan.  If to swap its fixed interest rate payment for the floating interest rate payments of another: interest swap  If to swap currencies of debt service obligation: currency swap  A