Borrowers Objectives

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1 FIN 463 International Finance Cross-Currency and Interest Rate s Professor Robert Hauswald Kogod School of Business, AU Borrowers Objectives Lower your funding costs: optimal distribution of risks between parties look at the project from your lenders perspective Default risk: problematic since almost unhedgeable use the particular structure of investments: collateral Credit Default s: limited number of liquid names guarantee: only as good as the guarantor lender bears cost: spread over benchmark Two easily hedged risks: FX and interest use hedge to lower your borrowing costs! 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 2

2 Interest and FX Rate Outlook, Bond Pricing and Issuing Analyze FX and interest rate environment by statistical methods, market analysis reconcile your own opinion with funding needs Levels: security type and structure high interest rates: floating low interest rate: fixed or capped floating Volatility: segment, deal type and timing low volatility: little advantage in repackaging high volatility: funding arbitrage, swaps Risk management includes good judgement 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 3 XFX and Interest Rate s Plain-vanilla swaps: FI risk management 2 segments: FX and interest rate swaps principle: match exposures and positions Generally applicable risk management ideas: build risk management into strategies second chance: deal with risks after the fact Divide and conquer : repackaging risks ex ante: lower your borrowing costs ex post: repackage your risks 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 4

3 Basic Toolkit A&L matching: offsetting risks on balance sheet one party s risk might be the other s opportunity trading off risks: FX and default, FX and interest Fixed income security structure: distributes risks embedded options: call (prepayment) or put rights coupon: fixed or floating Derivatives: re-package original financing with swaps: FX, interest rate or FX-interest rate swaps options (insurance) : FX, yield (interest rate) embedded options: structure of bond 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 5 Fundamentals In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals exchange of cash flows contractually fixed: dates, size, obligation Single currency interest rate swap: Plain vanilla fixed-for-floating swaps are often just called interest rate swaps Cross-Currency interest rate swap currency swap; fixed for fixed rate debt service in two (or more) currencies 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 6

4 Origin of Markets New phenomenon: 1970s and 1980s currency transactions between central banks first interest rate swap: 1982 Causes: market segmentation financial arbitrage: comparative borrowing advantages tax and regulatory arbitrage risk management tool financial integration Future: adverse publicity vs. financial needs 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 7 Size of the Market: 2004 In 2004 the notational principal of: interest rate swaps was $127,570 billion USD. currency swaps was $7,033 billion USD The most popular currencies are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 8

5 Size of the Market: 2012 In 2012 the notational principal of: Interest rate swaps was $370 trillion USD. Currency swaps was $25.4 trillion USD. The most popular currencies are: U.S. dollar Euro Japanese yen Swiss franc British pound sterling 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 9 Interest Rate Volumes: USD, EUR, GBP, JPY 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 10

6 Cross Currency s (BIS) 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 11 The : Dealer/Trader A swap bank is a financial institution that facilitates swaps between counterparties. The swap bank (generic term) can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 12

7 Market Quotations banks will tailor the terms of interest rate and currency swaps to customers needs They also make a market in plain vanilla swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 13 Interest Rate Quotations Euro- Sterling Swiss Franc USD JPY Bid Ask Bid Ask Bid Ask Bid Ask Bid Ask 1 year year year year year means 0.57 the 1.24 swap 1.24 bank 0.11 will year pay 1.06 fixed-rate euro 0.49 payments at % year against receiving USD 1.41LIBOR or it will 0 8 year year receive fixed-rate euro 1.56payments 0.04at year % against 0.17 paying USD 1.62 LIBOR For 12 year years NA NA year year year NA NA NA NA 30 year /2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 14

8 From Interest Rate To Cross Currency Quotations Euro- Sterling Swiss franc U.S. $ Bid Ask Bid Ask Bid Ask Bid Ask 1 year year means 0.11 the swap 0.19bank 0.42 will year pay fixed-rate euro payments at 1.74% 4 year against receiving USD LIBOR or it will 5 year receive fixed-rate euro payments at 6 year % against paying USD LIBOR. 7 year year year year /2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 15 Quotations: Underlying means the swap bank will pay fixed-rate euro payments at 1.74% against receiving USD LIBOR or it will receive fixed-rate euro payments at 1.78% against paying dollar USD LIBOR. B 1.78% USD LIBOR 1.74% USD LIBOR A While most swaps are quoted against flat dollar LIBOR, offmarket swaps are available where one party pays LIBOR plus or minus some number. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 16

9 Cross-Currency Deal: Exchange Principal = Debt Service Consider s A and B: A is a U.S. MNC who wants to finance a euro denominated asset in Italy, and therefore wants to borrow 40 million for 3 years. A can borrow euros at 6%. B is a French MNC who wants to finance a dollar denominated asset, and therefore wants to borrow $60 million for 3 years. B can borrow dollars at 8%. $ A $7% 6% B $8% 5% The current exchange rate is $1.50 = /2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 17 Example of a Currency Suppose that the publishes these quotes. The convention is to quote against U.S. dollar LIBOR. Euro- U.S. $ Bid Ask Bid Ask 3 year A wants to finance a euro-denominated asset in Italy and wants to borrow euros. It can borrow euros at 6% or it can borrow euros at 5.2% by using a currency swap. $ A $7% 6% B $8% 5% 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 18

10 Currency Euro- U.S. $ Bid Ask Bid Ask (The convention is to quote against U.S. dollar LIBOR.) $7.0% X $60m A $ A $7% 6% B $8% 5% LIBOR $7.0% 5.2% Suppose that A borrows $60m locally at $7% and then trades $60m for 40m at spot. $60m 40m LIBOR A then enters into 2 fixed for floating swaps. FOREX Market 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 19 Currency Euro- U.S. $ Bid Ask Bid Ask (The convention is to quote against U.S. dollar LIBOR.) $ A $7% 6% B $8% 5% LIBOR $7.2% 5.0% LIBOR B 40m $60m FOREX Market 40m 5% Y Suppose that B borrows 40m locally at 5%, then trades 40m for $60m. B then enters into 2 fixed for floating swaps. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 20

11 X A Currency The swap bank earns 40bp per year (20bp in $ and 20bp in ). $7.0% $7.2% 5.2% 5.0% The notional size is $60m. The tenor is for 3 years. B A earns 80bp per year on the swap and hedges exchange rate risk. B earns 80bp per year on the swap and hedges exchange rate risk. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 21 Y Cash Flows of the s: T = 0 A B X Foreign Exchange Spot Market 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 22 Y

12 Assume LIBOR T=0 = 3%. X Cash Flows of the s: T = 1 A $1.8m $4.2m 2.08m $1.8m A s all-in-cost = 2.08m or 5.2% of 40m $1.8m $4.32m 2m $1.8m B The swap bank earns 80,000 + $120,000 or m $60m per year. B s all-in-cost = $4.32 or 7.2% of $60m 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 23 Y Assume LIBOR T=1 = 4%. X Cash Flows of the s: T = 2 A $2.4m $4.2m 2.08m $2.4m A s all-in-cost = 2.08m or 5.2% of 40m $2.4m $4.32m 2m $2.4m B The swap bank earns 80,000 + $120,000 or m $60m per year. B s all-in-cost = $4.32 or 7.2% of $60m 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 24 Y

13 Cash Flows of the s: T = 3 Assume LIBOR T=2 = 5%. A $3m $4.2m 2.08m $3m $3m $4.32m 2m $3m B X Foreign Exchange Forward Market 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 25 Y Equivalency of Currency Debt Service Obligations We can assume that IRP holds between the 5% euro rate and the $7% dollar rate. This is reasonable since these rates are, respectively, the best rates available for each counterparty who is well known in its national market. According to IRP: S t ($/ ) = S 0 ($/ ) (1 + i $) t (1 + i ) t S 1 ($/ ) = $1.50 (1.07)1 $ (1.05) 1 = 1.00 $ A $7% 6% B $8% 5% 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 26

14 IRR % $60.00 $4.20 $4.20 $ % The swap bank could borrow $60m at 7% and use a set of 3 forward contracts to redenominate the bond as a 5% euro bond. 40m = $60m 1.00 $ (1.05) 2.75m = $4.20m $1.50 (1.07) 1.00 (1.05) m = $4.20m $1.50 (1.07) (1.05) m = $64.20m $1.50 (1.07) 3 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 27 IRR % $60.00 $3.06 $3.12 $ % The swap bank could borrow 40m at 5% and use a set of 3 forward contracts to redenominate the bond as a 7% dollar bond. $60m = 40m $1.50 $1.50 (1.07) 1.00 $3.06m = 2m 1.00 (1.05) $1.50 (1.07) 2 $3.12m = 2m 1.00 (1.05) 2 $1.50 (1.07) 3 $66.67m = 42m 1.00 (1.05) 3 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 28

15 The Quality Spread Differential The Quality Spread Differential (QSD) represents the potential gains from a swap that can be shared between the counterparties and the swap bank. There is no reason to presume that the gains will be shared equally. The QSD is calculated as the difference between the differences. $ A $7% 6% B $8% 5% QSD 1% 1% = 2% 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 29 Interest Rate Transaction Fixed Floating A 5% LIBOR B 5.50% LIBOR +.20% Consider s A and B; each firm wants to borrow $40 million for three years. A wants to finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate. A has good credit and can borrow at LIBOR. B wants to finance an interest-rate-insensitive asset and thus wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow fixed at 5.5%. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 30

16 Interest Rate A 5.10% LIBOR X If A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of , they can convert their fixed rate 5% debt into a floating rate debt at LIBOR 0.10%. A s all-in-cost = LIBOR 0.10% = 5.0% + LIBOR 5.10% 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 31 Interest Rate 5.20% LIBOR B If B borrows floating from their bank at LIBOR % and takes up the swap bank on their offer of , they can convert their floating rate debt into a fixed rate debt at 5.40%. B s all-in-cost = 5.40% = LIBOR + LIBOR % % 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 32 Y

17 Interest Rate A 5.10% LIBOR 5.20% LIBOR B The swap bank makes 10 basis points on the deal. The swap bank s all-in-cost: 0.10% = LIBOR + LIBOR 5.20% % Note that a negative cost means a profit. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 33 Interest Rate A 5.10% LIBOR 5.20% LIBOR B X The notional size is $40 million. The tenor is for 3 years. A earns $40,000 per year on the swap. B earns $40,000 per year on the swap. The swap bank earns $40,000 per year. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 34 Y

18 Transforming a Liability A has transformed a fixed rate liability into a floater. A is borrowing at LIBOR.10% A savings of 10 bp. 5.10% X 5.0% A LIBOR B has transformed a floating rate liability into a fixed rate liability. B is borrowing at 5.40% A savings of 10 bp. 5.20% LIBOR B LIBOR +.2% 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 35 Y What about the Principal? In our plain vanilla interest-only interest rate swap, we did not mention swapping the Notational Principal. It could be the case that A exchanged principal with their lender, X, and B exchanged principal with their outside lender, Y. But: to minimize counterparty risk no principal is exchange XFX swaps: principal needs to be exchanged only swap with principal exchange: to swap debt service 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 36

19 Interest-Only : T = 0 Cash Flows A B X 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 37 Y X Interest-Only : T = 1 Cash Flows Assume LIBOR T=0 = 3%. A $2,040,000 $2,080,000 $1,200,000 $1,200,000 The swap bank earns $40,000 per year. A saves $40,000 per year relative to borrowing at LIBOR = 3%. B saves $40,000 per year relative to borrowing at 5.5%. B 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 38 Y

20 X Interest-Only : T = 2 Cash Flows Assume LIBOR T=1 = 4%. A $2,040,000 $1,600,000 $2,080,000 $1,600,000 The swap bank earns $40,000 per year. A saves $40,000 per year relative to borrowing at LIBOR = 4%. B saves $40,000 per year relative to borrowing at 5.5%. B 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 39 Y Interest-Only : T = 3 Cash Flows Assume LIBOR T=2 = 5%. X A $2,040,000 $2,000,000 $2,080,000 $2,000,000 The swap bank earns $40,000 per year. A saves $40,000 per year relative to borrowing at LIBOR = 4%. B saves $40,000 per year relative to borrowing at 5.5%. B 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 40 Y

21 Variations of Basic Currency and Interest Rate s Currency swaps: Fixed for fixed Fixed for floating Floating for floating Amortizing Interest rate swaps: Zero-for floating Floating for floating For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 41 True Arbitrage? Credit risk faced by a swap dealer and customers (Lehman!) the major risk; counterparty will default on its end of the swap. Interest rate risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Exchange rate risk: swap bank loses if the GBP appreciated Basis risk: floating legs are not pegged to the same index Mismatch risk : warehousing risk Finding a counterparty that wants to borrow the right amount of money for the right amount of time. Sovereign risk The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 42

22 Summary: Putting It All Together s: exchanging two liabilities ex-ante: optimize funding and borrowing costs ex-post: manage adverse FX or interest rate shocks Create synthetic instruments and gain twice: issue in preferred market segment swap into needed currency or coupon structure FI financial engineering: repackage cash flows use market imperfections for return enhancements pay only 1.5 times for two or more transactions statistical models: limit exposures, track VAR 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 43 Appendix: Transactions Pricing swaps: fixed income mathematics Foreign currency fixed-for-fixed swap Walt Disney s synthetic JPY bond Fixed-for-floating (plain vanilla) interest rate swap: Radobank and Goodrich synthetic floating rate note and fixed rate bond Floating rate risk: buying insurance caps and floors 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 44

23 FX + Interest Rate =? Two currencies, X and Y, have both fixed-rate and floating-rate segments. For example, with an interest rate swap in currency X (AB) and a fixed-fixed currency swap (AC), we can construct a cross currency interest rate swap (BC). Similarly... Currency of Denomination Currency X Currency Y Fixed Rate Asset or Liability Fixed-Fixed Currency Interest Rate Base Interest Rate Floating Rate Asset or Liability A Interest Rate B 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 45 C Cross Currency Interest Rate Floating-Floating Currency D Pricing s A swap is a derivative instrument so it can be priced in terms of the underlying assets: Plain vanilla fixed-for-floating: valued just like a bond. XFX swap: valued just like a nest of currency futures. prices reflect forward prices: swaps are series of forward contracts transaction costs: spreads carry over from the appropriate market segments - tied to benchmark credit risk: similar to FIF; essentially a counterparty (default) risk as measured by spread over benchmark arbitrage: imposes bounds/restrictions on prices 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 46

24 FX and Synthetic Funding Goldman Sachs for Disney: HBS Case , 1987 A&L: Disney needed JPY liability for FX risk management borrowing opportunity in XEU (ECU) use proceeds to refinance USD debt: interest rate management : payment streams fixed ECU ECU French Utility floating JPY JPY Disney 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald Time 47 Financial Engineering: Synthetic JPY Bond Fixed-for-fixed currency swap: pricing by IRR IRR argument follows from preceding picture FX markets: intervene in fixing the principal amount Reasons for advantageous swaps: GDF and Disney had saturated investor demand in their respective Eurobond segments issue on the other party s home turf and swap Disney creates an artificial JPY Eurobond XEU (ECU) bond + XEU-for-JPY swap = JPY bond cash flows gains twice: lower cost on XEU, swap gains 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 48

25 Interest Rate s Comparative advantage: Goodrich: Radobank: total savings from swap: Floating Fixed Rating Goodrich LIBOR BBB Radobank LIBOR AAA Difference Synthetic debt: compare to benchmarks Radobank: issue fixed, swap into floating Goodrich: issue floating, swap into fixed rate debt each party keeps track of three cash flows Radobank - B.F. Goodrich, HBS , /2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 49 X-FX Interest Rate s Comparative advantage: Beirut Power and Light: Deutsche : Synthetic debt: compare to benchmarks BPL: Deutsche : Cash flows: two outflows, one inflow BPL: Deutsche : Floating USD Fixed DEM Rating Beirut P&L LIBOR BBB Deutsche LIBOR 7.00 AA Difference 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 50

26 Floating Rate Risk Management Interest rate risk with an attitude: opinions betting on falling rates: floating rate debt buy insurance: cap the rates Interest rate cap: up-front premium an option-like instrument that pays the holder the difference between some index and actual rate floater + cap: rates stay below a certain ceiling Synthetic bonds: instruments plus swaps analyze interest rate sensitivity and pick vehicle combine swap with option: swaption 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 51 Valuation of an Existing A swap is a derivative security, so valuation can be done with reference to the value of the underlying assets. How to value a swap: Any swap s value is the difference in the present values of the payment streams that are incoming and outgoing. Plain vanilla, fixed for floating swaps get valued just like a pair of bonds. Currency swaps get valued just like two nests of currency forward contracts. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 52

27 Valuation Example A currency swap has a remaining life of 18 months. It involves exchanging interest at 14% on 20 million for interest at 10% on $30 million once a year. The term structure of interest rates is currently flat in both the U.S. and the U.K. If the swap were negotiated today, the interest rates exchanged would be $8% and 11%. All rates were quoted with annual compounding. The current exchange rate is $1.65 = 1. What is the value of the swap (in USD) to the party paying dollars? 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 53 Valuation Example m 2.8m $3m $3m Value of the swap to the party paying dollars: $8,335,659 = 2.8m 2.8m (1.11) ½ + (1.11) 3 /2 $ $5,559,669 = $2,775,990 $3m $3m (1.08) ½ + (1.08) 3/2 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 54

28 Second Valuation Example Find the dollar value today to the party paying dollars of a 7-year old swap with 3 years remaining maturity. The swap calls for exchanging interest only on 10m at 5% for $15m at 3%. Semiannual payments, and the last payment was yesterday. Today s exchange rate is $1.30/ and the AAA rate is 2% in the U.S. and 2.5% in the euro zone. 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 55 Valuation Example 2 N 6 Find the value of the swap as the net I/Y 2.5% value of a portfolio of two bonds: CPT PV - 1,436, Long a euro denominated bond and 2. Short a dollar denominated bond PMT 250,000 = ( 10m.05) /2 (semi-annual pay bond) FV 0 (NOT 10m since this is an interest-only swap.) dollar value = 1,436, $1.30/ 1 = $1,867, N 6 I/Y 2.0% CPT PV -$1,303, PMT $225,000 = ($15m.03) /2 (semi-annual pay bond) FV $0 (NOT $15m since this is an interest-only swap.) The value of this swap to the party paying dollars is $563, (= $1,867, $1,303,982.21). 10/2/2018 Global Risk Management Techniques - Robert B.H. Hauswald 56