Corporate Risk Management

Transcription

1 Cross Currency Swaps: Theory and Application Incorporating Swaps in Treasury Risk Management While corporate treasury executives are well versed in conventional interest rate swaps to manage exposure to fixed or floating interest rates, many are not as familiar with the cross currency equivalent. Yet, these products have many of the same features as an interest rate or currency swap, are priced using the same underlying assumptions, and have a wide range of applications in corporate risk management covering both foreign exchange and interest rates. They are also quite common and widely traded; the largest Swap Execution Facilities reported an average Dollar volume of $170bln per month in In the following paper, we seek to define the cross currency swap product and then present the applications that are gaining increasing levels of interest from the corporate community. Swap Product Overview Regardless of form, all swaps are obligations to exchange one series of cash flows for another. They are often in the same currency such as interest rate swaps where one party exchanges a series of variable interest rate payments for fixed or where one wishes to change the basis of their exposure from say semi-annual to a quarterly Libor equivalent. In each case, the obligation to exchange cash flows on a pre-defined series of dates and an observable discounting mechanism make each variation possible by equating the present value of each series of cash flows at the time of initiation. PV of Floating Libor Curve Equal at Initiation PV of Fixed Rate Equivalent Consider an interest rate swap where your obligation is in floating rates. While future rates are unknown, it is possible to use a recognized discounting curve to present value the market s future rate expectations and solve for a fixed equivalent so that, at initiation, the expected value of the floating rate is equal to the fixed rate. For the borrower, such a swap transforms uncertain future floating payment to a known series of fixed payments. 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% The Cross Currency Equivalent The most basic function of the cross currency swap is its ability to transform assets or liabilities representing a series of cash flows from one currency to another in either a fixed or floating format. Because these instruments exchange obligations in different currencies, there are a few significant changes from single currency interest rate swaps. These are: An exchange of principal often at initiation and at maturity. While the initial exchange is optional, the final exchange, in either an amortized or bullet form, is usually included An observable discounting curve in both currencies A reference spot rate which converts all the cash flows to a single currency for valuation purposes Consider the simplest form of a cross currency swap with which you may already be familiar; the basic FX swap where one sells & buys a fixed amount of one currency in exchange for another on a future date. In this case there is an initial exchange at spot and a final exchange at maturity. We also know the relevant interest rates for each currency which is expressed as an adjustment to the final exchange rate in terms of forward points. However, the difference in rates could also be expressed as a stand-alone cash flow which is either earned or paid depending on who owns the higher yielding pair while the principal is exchanged based on a fixed spot rate. Both methods generate the same economic value, but the FX swap allows for a more efficient exchange at a single rate that incorporates the interest and principal rather than exchange multiple cash flows. Like the FX swap, the cross currency equivalent is an exchange of principal amounts at the same spot reference and a series of interest rate payments both earned and paid. Both the interest payments and the final exchange are present valued based on the initial spot rate and the interest rate on one leg of the swap is solved against a reference obligation rate to yield zero cost at initiation. This reference rate is often the original exposure that is being transformed and the solved rate is the resulting cost of the payment. For example, in a rate market, if you are borrowing at floating 3M Libor +250 and wish to swap to fixed, the reference index is the original obligation of 3M Libor If we are swapping this to a fixed equivalent, the fixed rate is solved to yield a NPV of zero on both legs. This also represents the dealing price of the swap as it is the only variable unknown at initiation. Page 1

2 What values go into the pricing calculation is a combination of both visible inputs such as rate curves and discount factors, but also less visible components such as client credit costs, regulatory charges and the impact of the cross currency basis. Of these, credit is often visible in the reference rate as the spread to Libor. However, with the proliferation of regulatory costs imposed on swap counterparties, there will be individual spreads added to the cost of the reference rate unique to each bank s credit calculations. We at Citizens feel we are broadly in-line with recent market trends and comply with regulatory guidelines on spreads to cover the costs of capital and the margining required for ensuring systemic stability. The Role of the Cross Currency Basis The cross currency basis is the last input of valuation. While it was the least understood component outside the narrow interbank funding market, it has soared to prominence following the financial crisis. Prior to 2008, theoretical concepts such as covered interest parity and no-arbitrage The haircut charged to those synthetic Dollar borrowers is expressed as a negative cross currency basis. Using the Euro as a practical example, this implies that a European financial institution that borrows at Euribor from the ECB will receive Euribor minus the basis in return for receiving Dollars and paying Libor to a swap market counterparty. The difference between the original Euribor borrowing cost and the Euro interest received in the swap is the cost of Dollars in the cross currency market. This is expressed in a pure basis point cost adjustment for Dollar funding. Of course, if it is expensive to borrow in foreign currency and swap into synthetic Dollars, the reverse must also be true. For those who can borrow in Dollars and have a need to swap into foreign currency debt, there was no haircut at all. In fact, foreign funding comes at a discount when Dollars were being lent as part of the cross currency swap. Again extending this to the EUR example, for US firms with Dollar credit facilities, should they swap the debt into Euros, the cross currency basis is expressed as a reduction in the rate of Euro interest that they have to pay to service the synthetic debt. Applications Alternatives: The Use of Synthetic Debt market conditions generally held in the cross currency swap market on the belief that so long as the currency risk is immunized, swapping debt from one currency to another in the interbank market was largely a frictionless exercise. The financial crisis proved this was anything but. At the time, the global financial system was desperate for Dollar funding to service Dollar liabilities and foreign borrowers turned to the FX space to convert plentiful local borrowing into scare Dollars. Unfortunately, the supply of those Dollars became finite and US dealers, having reached their counterparty credit capacity, started pricing in a haircut on the amount of interest they would pay on foreign currencies they received to lend Dollars. This adjustment to the price of the swap seems to violate classic arbitrage pricing, yet it remains a persistent element of swap pricing and valuation. For those US firms who wish to obtain foreign currency denominated funding, the traditional route was either via multicurrency borrowing facilities or non-dollar bonds issued in offshore markets. Yet, multi-currency bank facilities are often ear-marked for funding operations or dealing with seasonal volatility while many firms do not have access to off-shore bond markets for more long-term funding. However, a swap is all about transforming one series of cash flows to another and nowhere is this more topical than the recent trend of corporates seeking foreign funding by swapping US debt into lower yielding foreign debt. Not only does non-dollar debt offer Page 2

3 savings in terms of lower yield levels, the aforementioned cross currency basis can potentially lower the effective interest rate even further for those who chose to create debt synthetically via a swap. Let s build out our theoretical ideas with a more practical example. In this case, we assume that our US corporate has a USD term facility which it services by cash flows from operations. Given that it has a growing international presence, our corporate client would like to have some of its debt denominated in another currency to match its growing revenue and asset mix in Europe. Unfortunately, while our corporate client is moving up in the world, it is not yet known to the European debt markets and, as such, is not able to efficiently issue Euro denominated debt or it doesn t want to increase its existing stock of debt simply to provide an offset to rising exposure to the Euro. Similarly, while it could get USD loans from its banking group, unless it wanted to tap multi-currency facilities, its access to Euro denominated debt is difficult to source organically. Next let s assume that our corporate client wishes to have five year Euro denominated debt with a similar payment of principal at maturity. Via the cross currency swap, the face value of the US term loan debt is converted to a Euro amount at the spot rate and the expected interest cost based on 3M Euribor cash flows is calculated. In addition, the final principal amount is converted to Euro also at the current spot rate. Both the USD series of cash flows and the resulting Euro series of cash flows are discounted to present value and the spread applied to the Euro interest rate to address credit costs and regulatory charges. The result is a floating to floating cross currency swap where the initial and final values of the US debt are converted to Euro and then back to USD at the initial and final payments of the swap. Over the life of the loan, Citizens pays the corporate client 3M USD Libor+250 and in return receives 3M Euribor adjusted for a spread which is solved for such that the series of cash flows is discounted to PV and has equal value in reference Dollar terms at initiation. Overview of a XCCY Swap to Pay Euros and Receive Dollars Present Value of Dollar Principal Received at Maturity Floating Rate Loan L+250 Corporate Borrower Present Value in Euro Initial Exchange Present Value of Dollars Received from Swap Counterparty Final Exchange L+250 Euribor + Citizens Global Markets Equal at Initiation Present Value in USD Initial Exchange Present Value of Euros Paid to Swap Counterparty Present Value of Euro Principal Paid at Maturity Final Exchange What our corporate client does have is US Dollar debt in the form of a five year term loan that was recently priced at 3M Libor+250. Could the corporate utilize these liabilities as the basis for the creation of the desired European debt Let s look at the cash flows. Our corporate has to pay its creditors 3M Libor+250. In five years time, it has to pay back the notional Dollar principal. Given that this is the very liquid USD market, there is a 3M Libor curve and the concurrent ability to discount the quarterly stream of Dollar interest and the final repayment of the loan back to present value. Clearly, one half of the requirements of a swap are in place. What s been achieved here The corporate has a term loan obligation in USD to pay 3M Libor +250 and repay the final principal. In the cross currency swap, they receive these cash flows from their bank swap counterparty so their exposure to their creditor obligations is evenly matched. In return for receiving the Dollar series of cash flows, they pay a series of cash flows in Euros referenced to 3M Euribor and in five years they pay a Euro denominated principal. In all facets, their Euro obligation is analogous to the issue of a Euro denominated bond in that there is a legal obligation to pay interest and principal. However, this client never touches the Euro debt Page 3

4 market or requires a multi-currency facility. The equivalent position is created via the cross currency swap. Outside the novel ability to synthetically create a Euro denominated bond, why would a corporate be attracted to the European debt market Here we jump from financial theory to corporate finance where the use of debt serves several strategic functions. All things being equal, the issuer of debt wants two things; the lowest interest rate possible and the ability to repay the obligation. Lower interest costs improve financial performance by lowering OI&E on the income statement and improving cash flow from financing activities on the statement of cash flows. If the business in Europe has a history of producing positive cash flow, the use of debt / operating leverage can improve on key metrics such as return on equity particularly if the cost of Euro debt is lower than the cost of USD based funding from the parent. All businesses are built on a capital structure of both debt and equity. Matching debt to its source of payback is the key and here we look into debt ownership and the functional currency. In our example, the USD parent is the entity that owns the debt exposure via the Dollar term loan. Swapping Dollar debt to Euro debt at the parent level creates a monetary exposure to the EURUSD exchange rate with P&L implications as the debt exists at the wrong functional currency entity. Instead, the parent s Euro functional subsidiary is the entity that should hold and service the debt. To effect this and remove the accounting volatility, the parent loans Euro to the European subsidiary in the form of an intercompany loan with terms equal to what is available in the cross currency swap market. While the parent could lend the subsidiary Dollars, the exposure would be transferred to the sub and any hedging would have to be in that entity s name and bank credit would most likely require a parent guarantee. Once again, the swap allows debt to be placed at the appropriate functional currency entity that owns payback ability while dealing credit stays at the parent level. By lending the sub Euros, the net result is: The Euro functional sub has a Euro loan from the parent with no currency exposure or hedging need The parent has an intercompany loan in a non-functional currency creating an exposure eligible for cash flow accounting to remove earnings volatility The parent credit secures the cross currency swap that provides for the loan hedge and the receipt of cash flows to service the original Dollar loan Interest Payments of a XCCY Swap as a Hedge of a Intercompany Loan Floating Rate Loan L+250 Corporate Borrower Libor +250 Citizens Global Markets Accounting Implications of an Intercompany Loan Hedge The accounting impact of the cross currency swap as a hedge of the intercompany loan may be optimized if properly documented under ASC 815. While we will not go into the well-established documentation requirements in this paper, getting critical terms matching and hedge effectiveness established with the help of your auditor is not a difficult exercise and, in fact, will only get easier under the new FASB exposure draft set to take effect in Achieving cash flow hedge accounting will result in the following accounting impacts on the swap and the loan: Unrealized gain or loss on the loan due to FX spot changes will be recognized in the Income Statement, and will be offset by concurrent changes in value in the swap resulting in no current period P&L; any remaining offset needed is created through a corresponding entry to OCI Interest Expense will impact the Income Statement below the line with the net effect being a lower effective rate in Euro. As this is being received by the parent from the sub to be paid to the swap counterparty, there is no P&L exposure from changes in the coupon due to FX Changes in the present value of the swap due to market rate movements will remain in OCI until the underlying exposure is realized at which point they will be released into current period income along with the underlying exposure. Note that amortizing swaps will release OCI on the amortization schedule while pay-at-maturity swaps will have the entire OCI balance released at once. Given that there will be an underlying change in the loan in an equal and off-setting direction, there will be no net P&L impact Euribor + Euribor + European Subsidiary Page 4

5 The table below provides the off-setting impact on the income statement and the balance sheet. For each change in value realized by the parent for holding a Euro denominated loan, there is an offsetting change provided by the swap. Change in Loan Value Interest Paid on Loan Market change impact on swap PV Accounting Statement Impact of Cash Flow Hedge Income Statement Offsets Balance Sheet OCI Given the favorable economics of substantially lower interest rates available outside of the US and the widely accepted application of favorable cash flow hedge accounting applied to a cross currency swap, creating synthetic debt at the subsidiary level is a compelling solution to better match sources and uses of foreign cash. Alternative Applications as a Net Investment Hedge Change in Swap Value Interest Paid on Swap Market change impact on swap PV Having foreign denominated debt also serves other important accounting functions. Consider our corporate client once again. It is likely that they have made investments in the business over the years and that the consolidated balance sheet reflects the value of this net investment in the European operation. This book value is carried on the parent s Dollar denominated balance sheet at the historical rate with changes in FX resulting in gains or losses in the foreign equity reflected in the Cumulative Translation Adjustment or CTA. As long as the business is not sold, this component of shareholders equity absorbs the FX translation gains or losses on the European assets when they are remeasured back into Dollars for consolidated reporting purposes. What this implies is that the value of the balance sheet can become impacted over time due to large cyclical foreign currency weakness as foreign net investment values are revalued in Dollars. For some companies, this number is just a plug ; it is immaterial to the total value of the firm s equity. For other companies who have recently established an international presence or have a very high percentage of their assets located overseas, the value of equity might be far more important and changes in the value of consolidated equity might impact such key metrics as debt to equity ratios or impact credit quality. This is particularly true for those firms in the credit cycle where they face refinancing needs in the notto-distant future and wish to present the strongest balance sheet possible to secure their next funding rates. It has generally been possible to hedge eligible net investment using common foreign exchange derivatives as well as designating foreign debt as a natural hedge of investments in foreign operations. In fact, one of the oldest FX accounting standards is FAS 52 (now known as ASC 830) which outlines the treatment of balance sheet translation. The key distinction in this application is that while foreign debt would normally result in a monetary exposure with P&L implications, under the net investment designation, the change in value of the debt due to changes in FX spot rates is reclassified to CTA to match and offset the changes in equity value resulting from end-ofquarter re-measurement of the hedged foreign investment. The value of using the capital structure rather than derivative overlay has a certain appeal in that the existing debt mix most likely offers sufficient maturity and notional availability to apply as a net investment hedge notional. In this application, placement of debt is the key as the exposure to FX remeasurement risk can only be borne by the parent via foreign investment in subsidiaries. Therefore, the non-functional currency debt has to be held at the parent level. This raises several application issues to consider: The parent is considering an equity investment in the foreign subsidiary. In this case, Dollar debt is raised and via the cross currency swap, the principal is exchanged at initiation for currency which is invested in the sub. The resulting synthetic debt is classified as a net investment hedge against the starting equity value in the subsidiary. The parent already has existing Dollar debt and wants to hedge foreign subsidiary net investment for a period of years leading up to a significant refinancing. The cross currency swap without the initial exchange could convert the existing Dollar debt to foreign debt. The parent is considering selling the foreign subsidiary and wants to lock-in a Dollar equivalent value. Once again, short-term Dollar revolver facilities might be drawn and converted to currency with the net investment designation. Once the subsidiary is sold, the CTA balance is released and the proceeds of the sale are used to repay the short-term facilities. Page 5

6 There is also the potential to utilize the net investment hedge application to preserve the value of subsidiary equity that will ultimately be designated as dividended funds back to the parent. It is not possible to hedge the cash flow implications of the potential future exposure until the dividend is declared. Yet, as a dividend is simply a reduction in the equity value of the subsidiary, there is the potential to hedge the anticipated dividend amount via a net investment hedge of the targeted equity. In this application, gains/losses on the hedging instrument are deferred to CTA (and released to earnings once the subsidiary is sold or substantially liquidated) until dividends are declared. After that, the swap can be de-designated and marked to market through earnings to offset equivalent and opposite impact of remeasuring the dividend obligation at current exchange rates. The Spot Method As its name suggests, the spot method of effectiveness testing excludes all derivative value except for those associated with changes in the spot rate from period to period. This implies that interest paid / interest received or other valuation factors associated with the swap will be realized in current period income on the Income Statement. Changes due to spot movement reside in the Cumulative Translation Account (CTA) component of equity where changes in the foreign assets are also held. The Forward Method Under this metric, all changes in value of the swap are deemed to be effective and included in CTA with no income statement pass-through. Accounting Statement Impact of Net Investment Hedge Given the heightened interest in the potential for a legislative change on trapped foreign cash, this has become a very important topic. Recall that during the last dividend holiday over a decade ago, the amount that could be brought back at the lower tax rate was not the available cash held at the subsidiary level, but rather eligible net equity. Not only does this raise the prospect of hedging any anticipated dividends, but, more importantly, it also highlights the use of the cross currency swap as a way to provide the subsidiary sufficient liquidity to move total eligible net equity as this is often an amount far larger than available cash. Interest Paid FX Market Change in Sub FX Market Change in Swap Income Statement Offsets Spot Method Effectiveness Balance Sheet CTA Forward Method Effectiveness Interest Received FX Market Change in Sub FX Market Change in Swap Accounting Implications of a Net Investment Hedge The accounting impact of the cross currency swap as a hedge of eligible subsidiary net investment is largely removed if properly documented under ASC 815. However, there are important accounting and liquidity decisions that need to be considered and the first is whether the firm uses the Spot or the Forward method of effectiveness testing. Effectiveness testing is key as it defines how much of the change in value will be offset into equity and how much will potentially pass through into P&L. Net investment hedge accounting requires that a company designate either one of these methods to measure and, importantly, the decision can only be made once. For firms facing their first growing exposure to overseas assets, the decision might not have been codified. More established multinationals might have made a decision some time ago and that decision is difficult to reverse without a costly re-statement of historical results. Interestingly, survey evidence suggests that there is no strong bias by corporates for either method. There is also another issue to consider that is available only to those employing the cross currency swap as a net investment hedge. Unlike cash flow hedging, net investment hedges are allowed to have their notional value increased on a tax-gross up basis under ASC 815 in order for their after-tax return to equal the change in value of the underlying exposure. In this case, the available book value is divided by (1-tax rate) to derive the hedge-able notional value. Let s assume that our US client has a net investment exposure of EUR 10mln and a 35% tax rate. Should they desire, the maximum hedge amount could be as large as EUR 15.4mln to produce an after-tax offset equivalent to EUR 10mln. This is a valuable provision considering the potential size of any new dividend legislation where tax-savings is the primary motivator for firms to repatriate funds. It also highlights yet another important issue for cross currency swaps used as a net investment and that is the liquidity requirements to settle the hedge at maturity as well as the credit requirements needed for all swap applications. Page 6

7 Maturity Liquidity & Credit Considerations Like all debt, synthetic debt requires repayment at maturity. Depending on the application, changes in FX rates over the life of the swap could impact liquidity requirements should they decide not to roll the debt to a new maturity. First, consider the use of the swap as a hedge of an intercompany loan. As the subsidiary revenue is in the same currency as the loan, changes in the value of FX are relatively benign. It is a far different set of issues when confronting the liquidity considerations if the synthetic debt is used as a net investment hedge. The root cause for the difference is the distinction between a cash settled derivative and a non-cash producing balance sheet exposure. However, this concern is somewhat mitigated by the philosophical decision to hedge net investment in the first place. Let s expand on this a bit. For those companies who have made the decision to hedge the net investment in their subsidiaries to preserve the enterprise value of the firm in Dollars, it is typically a long-term risk management decision. Tactically hedging net investment on a periodic or short-term basis, while not prohibited, is common only if there is a need to protect the balance sheet in front of important events such as Brexit or the corporate client wants to ensure that the financials are solid going into a refinancing where unexpected changes in FX rates might impact the consolidated credit profile. At maturity, the swap can be cash settled but should there be a large FX move, the USD equivalent cost can be large if the net investment exposure was similarly sized. While a loss on the swap will be matched by a corresponding gain in the equity value of the foreign subsidiaries, this is a non-cash gain that does not provide liquidity against a large swap settlement. A similar argument can be made for those who systematically hedge net investment. On any maturity date, the underlying debt is likely to be rolled to a new maturity to continue to provide a hedge, but the cash settlement requirement remains. The same movement potential in the FX rate that creates the liquidity risk profile similarly creates the large credit requirement associated with most cross currency applications. Once traded, the value of the cross currency swap will change with movement in the interest rate market as future contractual payments are revalued. For floating rate swaps, there is lower sensitivity to rate changes than for the fixed rate equivalent. However, for both floating and fixed cross currency swaps, the FX rate will retain a far higher exposure to the value of the derivative as the final exchange represents a long-dated forward commitment with a linear sensitivity to currency moves. We mentioned client credit costs were an input into cross currency swap pricing and it is important to note that the potential future exposure of the currency is far larger than what exists in a vanilla interest rate swap. Depending on the volatility of the currency pairs, it is not uncommon for the credit usage of the cross currency swap to be multiples of the rate swap equivalents. For corporates who trade on an unsecured basis, it is important to understand the amount of bank credit that the swap might consume over the life of the trade. For those corporates who trade with some collateral agreement, there is the potential for substantial liquidity needs. The credit required for certain swap variations such as amortizing principal payments will lower the credit sensitivity by reducing the effective maturity or for those who can look at more structured alternatives, it is possible to incorporate some degree of optionality in the final exchange to lower credit. Summary Despite the depth of this document and the seeming complexity of the product, we return to our initial description of the cross currency swap: These instruments allow the user to transform assets or liabilities representing a series of cash flows from one currency to another in either a fixed or floating format. For a corporate client, this almost always is defined as creating synthetic debt in one currency based on organic debt carried in another. Given the decline in global rates in many economically important countries, this allows US clients the ability to access often cheaper foreign currency debt based of their existing USD bond or term facilities. However, raising synthetic foreign currency debt has to have a purpose and there are several very common risk management applications such as hedging intercompany loans or hedging the net investment in foreign subsidiaries that can take advantage of the cross currency swap product while enjoying hedge accounting in both instances. Like all derivative products, careful consideration needs to be given to the ancillary issues such as accounting, tax, liquidity and credit. Citizens Bank stands by to help our clients navigate these issues and provide the ideas, analysis and pricing that ultimately allow them to either reduce risk, save money, or potentially, both via the use of the cross currency swap. Page 7

8 Sample Term Sheet & Cash Flow Schedule The following example covers a fixed-to-fixed cross currency swap where the client swaps an existing USD 50,000,000 loan for synthetic EUR debt with the resulting debt held at the parent level as a Net Investment hedge of their foreign subsidiary. As the loan had already been drawn, there is no initial exchange. Disclaimer This document has been prepared for discussion and informational purposes only by Citizens Bank, N.A. and/or Citizens Bank of Pennsylvania ( Citizens ). In the preparation of this document, Citizens has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. Citizens makes no representation or warranty (expressed or implied) of any nature, nor does it accept any responsibility or liability of any kind, with respect to the accuracy or completeness of the information in this document. The information in this document is subject to change without notice and Citizens does not undertake a duty or responsibility to update these materials. The information contained herein should not be construed as investment, legal, tax, financial, accounting, trading or other advice. Under no circumstances should the information be considered recommendations to enter into transactions. You should consult with your own independent advisors before acting on any information herein. Citizens Bank, N.A. and Citizens Bank of Pennsylvania are whollyowned bank subsidiaries of Citizens Financial Group, Inc. Products and services are offered by either Citizens Bank, N.A. or Citizens Bank of Pennsylvania. Citizens Bank is a registered trademark of Citizens Financial Group, Inc. Copyright All rights reserved. Citizens Bank is a brand name of Citizens Bank, N.A. and Citizens Bank of Pennsylvania. Deposit accounts held at Citizens Bank, N.A. and Citizens Bank of Pennsylvania are separately insured. Unauthorized reproduction or use of any such trademarks or brand names is prohibited. For more information on this topic or other global markets risk management, you may reach the Citizens coverage desk at either: fx@citizensbank.com Page 8