Swaps December 1999 Swaps Warning This workbook is the product of, and copyrighted by, Citicorp North America, Inc It is solely for the internal use of Citicorp North America, Inc and may not be used for any other purpose It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of the Training and Development Centers for Latin America, Asia/Pacific and CEEMEA Please sign your name in the space below TABLE OF CONTENTS Introduction Course Overview v Course Objectives vi Workbook Guide .vii Unit 1: Customer Need for Interest-rate Hedges Introduction .1-1 Unit Objectives .1-1 Changes in Interest-rate and Currency Risks .1-1 Hedging Longer-term Interest-rate Risk .1-4 Hedging in the REPO Market 1-5 Associated Risks 1-8 Summary 1-9 Progress Check 1-11 Unit 2: Interest-rate Swaps Introduction .2-1 Unit Objectives .2-1 Evolution of the Interest-rate Swap 2-2 Reduction of Credit Risk and Tax Risk 2-2 Economic Value of the Contract 2-5 Interest-rate Swap Diagram 2-6 Summary 2-7 Progress Check 2-9 v12/01/99 p03/22/00 v-2.0 ii TABLE OF CONTENTS Unit 3: Currency Swaps Introduction .3-1 Unit Objectives .3-1 Relationship to Interest-rate Swap 3-1 Currency Swap Diagrams 3-2 Types of Currency Swaps 3-3 Fixed Versus Floating .3-3 Fixed Versus Fixed 3-3 Floating Versus Floating 3-4 Different View of Currency Swaps 3-5 Understanding Swap Contracts 3-6 Summary 3-7 Progress Check 3-9 Unit 4: Customer Uses of Swaps Introduction .4-1 Unit Objectives .4-1 Capital Market Uses of Swaps 4-2 Borrower Debt Versus Investor Return .4-3 Interest-rate Swaps 4-3 Currency Swaps 4-5 Converting Variable-rate Assets and Liabilities 4-7 Hedging Foreign Investment Capital 4-9 Swap Pricing .4-11 Summary 4-12 Progress Check 4-13 v-2.0 v12/01/99 p03/22/00 TABLE OF CONTENTS iii Unit 5: Accounting Treatment and Risk Management Introduction .5-1 Unit Objectives .5-1 Background 5-1 Tax and Other Regulatory Risks 5-2 Valuing Interest-rate Swaps 5-3 Viewing the Swap as a Bond Position .5-4 Valuing the Variable-rate Stream 5-5 Two Revaluation Methods 5-7 Mark-to-Market 5-11 Summary 5-12 Progress Check 5.1 5-13 Valuing Currency Swaps 5-17 Price Risk .5-19 Credit Risk .5-21 Customer Perspective 5-21 Bank Perspective 5-22 Summary 5-22 Progress Check 5.2 5-25 Unit 6: Special Forms of Swaps Introduction .6-1 Unit Objectives .6-1 Keys to Relationships .6-1 Short-term Foreign-exchange Forwards (STFX) .6-2 Long-term Foreign-Exchange Forwards (LTFX) .6-7 Forward Interest-rate Agreements (FRAs) .6-10 FRA Pricing .6-10 Assets and Liabilities 6-14 Summary 6-15 Progress Check 6-17 v12/01/99 p03/22/00 v-2.0 iv TABLE OF CONTENTS Appendices Appendix A Glossary — English A-1 Glossary — Spanish A-5 Appendix B ISO Codes B-1 Index v-2.0 v12/01/99 p03/22/00 Introduction A-2 GLOSSARY Floating-rate An earnings rate that changes from period to period based on a specified market index; also known as variable rate Forward Rate Agreement (FRA) Agreement to net the market-defined amount of interest on a given principal amount against a prespecified contract amount of interest, for a single period Hedge Elimination of exposure to risk by acquiring an offsetting position Interest-rate Risk Risk of an adverse change in interest rates over the life of an interest exposure with multiple rate reset periods Interest-rate Swap An exchange of payment streams in which the two cash flows are in the same currency and only the net amount of the cash flows is actually settled Liquidity Ability to convert assets into cash or equivalent, without significant loss, to meet the financial obligations of the bank LIBOR The London Inter-Bank Offer Rate “Long” Bond Position Position of dealer funding fixed-rate bond holdings with variable rates in the REPO market Long-term Foreign Exchange Forwards (LTFX) Commitment to buy or sell a currency in the future; the value date is usually more than one year after the spot value date Mark-to-Market (MTM) Revaluation Process of comparing the contract rate to current conditions using the net present value calculation Market Liquidity Measure of liquidity in terms of the time it takes to close positions in different markets v-2.0 v12/01/99 p03/22/00 GLOSSARY A-3 Net Present Value (NPV) Effect of interest on the value of money received or paid in different time periods Netting Calculation of the difference between the settlement rate and contract rate on the rate determination date to determine the amount of payment and which party pays Price Risk Risk of a loss resulting from the change in the swap rate and mark-to-market value Primary Market Swap Swap used at the inception of a debt offering to bridge the differing needs of issuers and investors in the primary issuance market Rate Determination Date Date which the settlement rate is determined Repurchase (REPO) Agreement An agreement to currently sell a security and then repurchase it in the future; REPOs are usually short-term (under one week) Secondary Market Swap Swap used for rate risk management after an asset or liability is established Settlement Date Date on which payment is determined, usually at the end of each payment period Settlement Rate Interest rate in the market on each rate determination date, based on an index such as LIBOR “Short” Bond Position A bond position opposite that of a “long” bond position which creates profits as interest rates rise; usually created by lending through the bond REPO market and selling the bond immediately v12/01/99 p03/22/00 v-2.0 A-4 GLOSSARY Short-term Foreignexchange Forwards (STFX) Commitment to buy or sell currency on a future date; the value date is usually one, three, six, or twelve months after the spot value date Spot Transactions for payment or settlement normally in two business days after the trading date Swap Rate Contract rate used in an interset-rate swap or currency swap Swap Spread Difference between swap rates and bond yields with the same maturity Tax Risk Risk that when parties exchange securities or when interest payments are made to foreign parties, the transaction may be subject to government taxes Term Currency Currency used to price the commodity currency (USD = SGD; the commodity currency is USD and the term currency is the Singapore Dollar.) Unrealized Gain Gain resulting from a positive mark-to-market valuation where the contract terms are more favorable than current market conditions Variable-rate See “Floating Rate” Volatility Mathematical expression of the likelihood of change in market rates Yield Curve Curve that represents interest rates for each different tenor of one financial instrument v-2.0 v12/01/99 p03/22/00 GLOSSARY A-5 APENDICE A GLOSARIO Commodity Currency/ Moneda de “Commodity” Una unidad monetaria cuyo precio está en términos de otra moneda (USD = SGD2.00; la moneda de commodity, el dólar está basado en términos del dolar Singapore Contract Rate/ Tasa de Contrato Tasa fija acordada al inicio de un contrato de swap Credit Risk/ Riesgo de Crédito El riesgo de que la contraparte no pueda o no quiera cumplir las obligaciones de un acuerdo Currency Risk/ Riesgo de Moneda El riesgo de un cambio adverso en las tasas de cambio Currency Swap/ Swap de Moneda Cambio de corrientes de pago en las cuales los dos flujos de caja se pagan en diferente moneda Fixed / Fixed Currency Swap/ Swap de Moneda Fijo / Fijo Un swap de moneda en el cual una corriente de pago fijo en una moneda se cambia por una corriente de pago fijo en otra moneda Fixed / Floating Currency Swap/ Swap de Moneda Fijo / Flotante Un swap de moneda en el cual una corriente de pago de tasa fija en una moneda se cambia por una corriente de pago de tasa variable en otra moneda Fixed Rate/ Tasa fija Una tasa de ganancia que permanece constante de periodo a periodo Floating / Floating Currency Swap/ Swap de Moneda Flotante / Flotante Un swap de moneda en el cual ambas corrientes de pago se basan en índices de tasa variable Floating Rate/ Tasa Flotante Una tasa de ganancias que cambia de periodo a periodo base en un índice específico de mercado; también conocido como tasa variable v12/01/99 p03/22/00 v-2.0 A-6 Forward Rate Agreement (FRA)/ Acuerdo de Tasa a Plazo GLOSSARY Acuerdo para liquidar la suma de intereses definida por el mercado en una suma principal dada contra una suma de intereses pre-especificada de un contrato, por un solo periodo de tiempo Hedge/ Cobertura Eliminación de la exposición al riesgo al adquirir una posición compensatoria Interest-rate Risk/ Riesgo de tasa de interés El riesgo de un cambio adverso en las tasas de interés a lo largo de la exposición de un interés periodos múltiples de fijación de tasa Interest-rate Swap/ Swap de tasa de interés Un intercambio de corrientes de pago en el cual los dos flujos de caja están en la misma moneda y solo la suma neta de los flujos de caja es realmente liquidada Liquidity/ Liquidez La capacidad de convertir activos en efectivo o equivalente, sin una pérdida significativa, para cumplir las obligaciones financieras del banco LIBOR/ LIBOR La Tasa de Oferta Interbancaria de Londres Long” Bond Position/ La posición del “dealer” convirtiendo “holdings” de bonos de Posición “Larga” de Bono tasa fija tasas variables en el mercado de REPOs Long-term Foreign Exchange Forwards (LTFX)/ Futuros a Largo Plazo de Cambio Extranjero Compromiso para comprar o vender una moneda en el futuro; la fecha valor es generalmente más de un año después de la fecha valor de contado Mark-to-Market (MTM) Revaluation/ Revaluación Mark-toMarket El proceso de comparar la tasa del contrato las condiciones actuales utilizando el cálculo de valor presente neto Market Liquidity/ Liquidez del mercado Medida de liquidez en cuanto al tiempo que toma cerrar posiciones en diferentes mercados v-2.0 v12/01/99 p03/22/00 GLOSSARY A-7 Net Present Value (NPV)/ Valor Presente Neto Efecto del interés en el valor del dinero recibido o pagado en diferentes periodos de tiempo Netting/ Netting El cálculo de la diferencia entre la tasa de liquidación y la tasa del contrato en la fecha de determinación de la tasa para determinar la suma de pago y la parte que debe pagar Price Risk/ Riesgo de Precio El riesgo de una pérdida resultante del cambio en la tasa del swap y el valor mark to market Primary Market Swap/ Swap de Mercado Primario Swap utilizado al inicio de una deuda que ofrece hacer puente en las diferentes necesidades de los emisores e inversionistas en el mercado emisor primario Rate Determination Date/ Fecha de Determinación de la Tasa Fecha en la cual la tasa de liquidación es determinada Repurchase (REPO) Agreement/ Acuerdo de Re-compra (REPO Un acuerdo para vender un valor y luego comprarlo nuevamente en el futuro; los REPO son generalmente a corto plazo (menos de una semana Secondary Market Swap/ Swap de Mercado Secundario Swap utilizado para el manejo de riesgo de tasa después de que un activo o pasivo es establecido) Settlement Date/ Fecha de Liquidación Fecha en la cual es pago se determina, generalmente al final de cada periodo de pago Settlement Rate/ Tasa de Liquidación Tasa de interés en el mercado en cada fecha de determinación de tasa, base en un índice tal como la LIBOR v12/01/99 p03/22/00 v-2.0 A-8 GLOSSARY Short” Bond Position/ Posición de Bono “Corta Una posición de bono opuesta a la posición de bono “larga”, la cual crea ganancias a medida que las tasas de interés aumentan; generalmente creada al prestar a través del mercado REPO de bonos y vender el bono inmediatamente Short-term Foreignexchange Forwards (STFX)/ Futuros a Corto Plazo de Cambio Extranjero Compromiso para comprar o vender moneda en una fecha futura; la fecha valor es generalmente un, tres, seis o doce meses después de la fecha valor de contado Spot Transaction/ Transacción de Contado Transacción para pago o liquidación normalmente en dos días hábiles después de la fecha de negociación Swap Rate/ Tasa swap Tasa de contrato utilizada en un swap de tasa de interés o un swap de moneda Swap Spread/ Margen de Swap Diferencia entre las tasas de swap y los rendimientos de bonos el mismo vencimiento Tax Risk/ Riesgo de Impuestos Riesgo de que cuando las partes intercambien valores o cuando se hagan pagos de intereses a partes extranjeras, la transacción puede estar sujeta a impuestos del gobierno Term Currency/ Moneda de Término La moneda utilizada para dar precio a la moneda del commodity (USD = SGD; la moneda del commodity es el dólar y la moneda del término es el dolar singapore.) Unrealized Gain/ Ganancia no realizada Ganancia que resulta de una valoración positiva mark-tomarket en la cual los términos del contrato son más favorables que las condiciones actuales del mercado Variable rate/ Tasa variable Ver “Tasa Flotante” Volatility/ Volatilidad Expresión matemática de la posibilidad de cambio en las tasas del mercado v-2.0 v12/01/99 p03/22/00 GLOSSARY Yield Curve/ Curva de Rendimiento v12/01/99 p03/22/00 A-9 Curva que representa las tasas de interés para cada vencimiento diferente de un instrumento financiero v-2.0 A-10 GLOSSARY v-2.0 v12/01/99 p03/22/00 APPENDIX B ISO CODES Code ARS AUD ATS BSD BHD BDT BBD BEF BZD BMD BOB BWP BND CAD CLP COP CYP CZK DKK DEM DJF DOP XCD ECS EGP EUR SVC ETB XEU FJD FIM FRF GMD GRD HTG HNL HKD HUF ISK INR IDR IEP ILS ITL JMD JPY v12/01/99 p03/22/00 Currency Argentine Peso Australian Dollar Austrian Schilling Bahamian Dollar Bahraini Dinar Bngladesh Taka Barbados Dollar Belgian Franc Belize Dollar Bermudian Dollar Bolivian Boliviano Botswana Pula Brunei Dollar Canadian Dollar Chilean Peso Colombian Peso Cypriot Pound Czech Koruna Danish Krone Deutsche Mark Djibouti Franc Dominican Peso East Caribbean Dollar Ecuadorean Sucre Egyptian Pound European currency El Salvador Colon Ethiopian Birr European Currency Unit Fiji Dollar Finnish Markka French Franc Gambian Dalasi Greek Drachma Haitian Gourde Honduran Lempira Hong Kong Dollar Hungarian Forint Icelandic Krona Indian Rupee Indonesian Rupiah Irish Pound Israel Shekel Italian Lira Jamaican Dollar Japanese Yen Code JOD KES KWD MGF MWK MYR MTL MUR MXN MAD NPR ANG NLG NZD NGN NOK OMR PGK PEN PLN PTE QAR SAR SCR SLL SGD ZAR ESP LKR SRG SEK CHF TZS THB TOP TTD TND TRL UGS AED GBP USD VEB ZMK ZWD v-2.0 Currency Jordanian Dinar Kenyan Schilling Kuwaiti Dinar Malagasy Franc Malawi Kwachi Malaysian Ringgit Maltese Lira Mauritian Rupee Mexican Nuevo Peso Moroccan Dirham Nepalese Rupee Netherlands Antilles Guilder Netherlands Guilder New Zealand Dollar Nigerian Naira Norwegian Krone Omani Riyal Papua New Guinea Kina Peruvian Nuevo Sol Polish Zloty Portuguese Escudo Qatar Riyal Saudi Riyal Seychelles Rupee Sierra Leone Singapore Dollar South African Rand Spanish Peseta Sri Lankan Rupee Surinam Guilder Swedish Krona Swiss Franc Tanzanian Shilling Thai Baht Tonga Pa’anga Trinidad & Tobago Dollar Tunisian Dinar Turkish Lira Ugandan Schilling United Arab Emirates Dirham UK Pound Sterling US Dollar Venezuelan Bolivar Zambian Kwacha Zimbabwe Dollar INDEX C Commodity Currency 6-3, 6-5 Contract Rate 2-3—2-7, 5-8, 5-17, 6-10 Credit Risk 1-8, 1-9, 2-1, 2-2, 2-5, 2-7, 3-2, 5-1, 5-2, 5-12, 5-21—5-23 Currency Risk 1-1—1-3, 3-7, 3-8, 4-8, 4-9, 4-11 Currency Swap 3-1—3-8, 4-1—4-3, 4-5—4-7, 4-8, 4-9, 4-11, 4-12, 5-17, 5-18, 5-22, 6-1—6-10, 6-14, 6-15 Fixed / Fixed Currency Swap 3-3—3-5, 3-8, 6-7 Fixed / Floating Currency Swap 3-2, 3-3, 3-5, 3-8, 6-2 Floating / Floating Currency Swap 3-3—3-6, 3-8, 4-5, 4-7, 6-2—6-7 F Fixed Rate 1-5—1-7, 1-9, 2-2, 2-3, 4-8, 4-11, 4-12, 5-9, 5-10, 5-18 Floating-rate 3-4, 4-3, 4-8, 4-9, 5-6 Forward Rate Agreement (FRA) 1-2, 6-10—6-15 H Hedge 1-1, 1-2, 1-4, 1-7—1-9, 2-1, 2-2, 2-4, 2-7, 3-1, 3-4, 3-7, 3-8, 4-1—4-3, 4-9—4-12, 5-21, 6-6, 6-9, 6-10, 6-14 I Interest-rate Risk 1-1—1-5, 1-8, 1-9, 2-1, 2-2, 2-7, 3-1, 3-7, 3-8, 5-4, 5-12, 6-2 Interest-rate Swap 2-1—2-8, 3-1—3-3, 3-5—3-8, 4-3—4-6, 4-8, 4-11, 4-12, 5-3, 5-4, 5-7, 5-12, 5-17, 5-22, 6-1, 6-2, 6-10, 6-14, 6-15 L Liquidity 4-2, 4-4 Market Liquidity v12/01/99 p03/22/00 5-21, 5-22 v-2.0 I-2 INDEX L (Continued) LIBOR 1-4, 1-5, 1-7, 1-8, 2-3, 3-3—3-5, 4-3— 4-9, 4-12, 5-7, 5-8 “Long” Bond Position 1-5—1-7 Long-term Foreign Exchange Forwards (LTFX) 4-10—4-12, 6-7, 6-9, 6-10, 6-15 M Mark-to-Market (MTM) Revaluation 5-11, 5-17, 5-19, 5-22, 5-23 N Net Present Value (NPV) 5-11, 5-18, 5-21, 5-23 Netting 2-5—2-7, 3-2, 3-7, 5-3, 5-9, 5-12, 6-1 P Price Risk 2-6, 5-1—5-4, 5-6, 5-7, 5-11, 5-12, 5-18—5-22 Primary Market Swap 4-1—4-3, 4-12 R Rate Determination Date 2-3—2-5 REPO 1-5—1-9, 2-1, 2-2, 2-7 S Secondary Market Swap Settlement Date Settlement Rate “Short” Bond Position Short-term Foreign-exchange Forwards (STFX) 4-1, 4-2, 4-9 2-3, 2-4 2-3—2-7, 3-4, 3-7 1-6, 1-7, 1-9, 2-2 6-2, 6-3 Spot 1-2, 3-2, 3-7, 5-17, 5-18, 5-22, 6-2—6-7, 6-9—6-11, 6-14 Swap Rate 4-11, 5-7, 5-9—5-11, 5-19, 5-20, 6-9—6-11, 6-14 Swap Spread 4-11 v-2.0 v12/01/99 p03/22/00 INDEX I-3 T Tax Risk 1-8, 1-9, 2-1, 2-2, 2-5, 2-7, 3-2, 3-7, 5-2, 5-3, 5-12 Term Currency 1-3, 6-3, 6-5 U Unrealized Gain 5-11, 5-22, 5-23 V Variable-rate 1-2—1-5, 1-7, 1-8, 2-2, 2-4, 4-2—4-5, 4-7, 4-11, 4-12, 5-2, 5-4, 5-5, 5-7, 6-15 Volatility 5-20, 5-22 Y Yield Curve 4-3, 5-7 v12/01/99 p03/22/00 v-2.0 I-4 INDEX (This page is intentionally blank) v-2.0 v12/01/99 p03/22/00 [...]... Interest-rate Swaps UNIT 3 – Currency Swaps UNIT 4 – Customer Uses of Swaps UNIT 5 – Accounting Treatment and Risk Management UNIT 6 – Special Forms of Swaps COURSE OBJECTIVES When you complete this workbook, you will be able to: n Describe the events and customer needs that led to the creation of swaps n Recognize the benefit of swaps from the perspective of swap users n Identify the risks inherent in swaps. .. in interest rates or currency exchange rates — swaps Specifically, we discuss interest-rate and currency swaps As used in this course, the term “swap” refers to these two forms of swaps only Foreign exchange swaps are covered in the FOREIGN EXCHANGE workbook Since the early 1980s, the volume of transactions in the swap market has increased dramatically; swaps have become the major influence in international... swaps and approaches to reducing swap risks n Identify the primary influences on swap pricing n Describe how banks assess and report swap risks n Recognize the relationships between interest-rate swaps, currency swaps, interest-rate forwards, and currency forwards v-2.0 v12/01/99 p03/22/00 INTRODUCTION vii WORKBOOK GUIDE This workbook is designed to give you complete control over your own learning The...INTRODUCTION COURSE OVERVIEW In this course, we will build upon concepts presented in other workbooks Before you begin your study of swaps, we suggest that you complete these self-instruction courses: n Interest Rates n Foreign Exchange n Futures In the INTEREST RATES course, we describe how borrowers use forward rate agreements (FRAs)... INTRODUCTION The 1970s were a turbulent time for the foreign exchange ( FX) and interest-rate ( IR) markets In the FOREIGN EXCHANGE and INTEREST RATE workbooks, we described how banks created FX forwards, FX swaps, and interest-rate forwards to help their customers hedge against unfavorable rate movements The same events that created a need for these products also gave rise to swap products In this unit, we... concepts and check your answers with the Answer Key If you answer any questions incorrectly, please reread the corresponding text to clarify your understanding Then, continue to Unit 2, Interest-rate Swaps v-2.0 v12/01/99 p03/22/00 CUSTOMER NEED FOR INTEREST-RATE HEDGES " 1-11 PROGRESS CHECK 1 Directions: Determine the correct answer to each question Check your answers with the Answer Key on the next... hedges for long-term interest-rate risk were: b) bond REPOs Question 5: REPO contracts created additional credit and tax risks for the counterparties v-2.0 v12/01/99 p03/22/00 Unit 2 UNIT 2: INTEREST-RATE SWAPS INTRODUCTION In Unit 1, you learned that investment banks used revolving term- REPOs to help their customers hedge longer-term interest-rate risk However, these contracts created additional credit... contracts designed to reduce credit risk and tax risk n Recognize the effect of these changes on the economic value of the interestrate hedge n Draw an interest-rate swap diagram v-2.0 2-2 INTEREST-RATE SWAPS EVOLUTION OF THE INTEREST-RATE SWAP In Unit 1, we described how the use of revolving term- REPOs to hedge interest-rate risks involved the exchange of a bond between a counterparty who wished to... +V1 Spot +V2 +V4 V3 1 yr -C/2 -C/2 +V5 2 yr -C/2 -C/2 +V6 +V7 3 yr -C/2 + Principal -C/2 +V8 4 yr -C/2 -C/2 - Principal Figure 2.1: Removing the Bond from a REPO v-2.0 v12/01/99 p03/22/00 INTEREST-RATE SWAPS 2-3 Net payments It became evident that the counterparties did not need to exchange the full amount of principal and interest at the end of the period, since each party would pay such amounts to... determined; these dates are usually at the beginning of each period Settlement Dates Dates on which payment is to be determined; these dates are usually at the end of each period v-2.0 2-4 INTEREST-RATE SWAPS Now that you know the components of an interest-rate swap agreement, you are ready to learn how they are used to determine the net payment The value of the settlement rate and contract rate on the