Origins of currency swaps

Transcription

1 Origins of currency swaps Currency swaps originally were developed by banks in he UK o help large cliens circumven UK exchange conrols in he 1970s. UK companies were required o pay an exchange equalizaion premium when obaining dollar loans from heir banks. How o avoid having o pay his premium? An agreemen would hen be negoiaed whereby The UK organizaion borrowed serling and len i o he US company s UK subsidiary. The US organizaion borrowed dollars and len i o he UK company s US subsidiary. These arrangemens were called back-o-back loans or parallel loans. 1

2 IBM / World Bank wih Salomon Brohers as inermediary IBM had exising debs in DM and Swiss francs. Due o a depreciaion of he DM and Swiss franc agains he dollar IBM could realize a large foreign exchange gain bu only if i could eliminae is DM and Swiss franc liabiliies and lock in he gain. The World Bank was raising mos of is funds in DM (ineres rae = 12%) and Swiss francs (ineres rae = 8%). I did no borrow in dollars for which he ineres rae cos was abou 17%. Though i waned o lend ou in DM and Swiss francs he bank was concerned ha sauraion in he bond markes could make i difficul o borrow more in hese wo currencies a a favorable rae. 2

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4 IBM / World Bank IBM was willing o ake on dollar liabiliies and made dollar paymens o he World Bank since i could generae dollar income from normal rading aciviies. The World Bank could borrow dollars conver hem ino DM and SFr in FX marke and hrough he swap ake on paymen obligaions in DM and SFr. Remark 1. The swap paymens by he World Bank o IBM were scheduled so as o allow IBM o mee is deb obligaions in DM and SFr. 2. IBM and he World Bank had AAA-raings; herefore he counerpary risk was low. 4

5 Exploiing comparaive advanages A domesic company has comparaive advanage in domesic loan bu i wans o raise foreign capial. The siuaion for a foreign company happens o be reversed. domesic bank domesic principal P d domesic company foreign company lend ou foreign principal P f foreign bank P d = F 0 P f domesic company ener ino a currency swap foreign company Goal: To exploi he comparaive advanages in borrowing raes for boh companies in heir domesic currencies. 5

6 Cashflows beween he wo currency swap counerparies (assuming no ineremporal defaul) domesic company domesic principal P d (iniiaion) periodic foreign coupon paymens c f P f foreign principal P f (mauriy) foreign company domesic company foreign principal P f (iniiaion) periodic domesic coupon paymens c d P d domesic principal P d (mauriy) foreign company Selemen rules Under he full (limied) wo-way paymen clause he nondefauling counerpary is required (no required) o pay if he final ne amoun is favorable o he defauling pary. 6

7 Cross currency ransacions The associaed cash flows are denominaed in differen moneary unis he principal amouns are usually exchanged a he originaion and mauriy daes. The exchange rae used can be eiher fixed or floaing a he prevailing rae a he ime of ransacion. The wo ineres raes can be eiher fixed or floaing. 7

8 Example Quoing prices The following raes are quoed for 3-year cross currency ineres rae swap agains he dollar. Canadian dollars Serling % (dealing spread of 25 bps) % (dealing spread of 20 bps) The quoed raes are he fixed raes ha he bank will pay (lower rae) or receive (higher rae) in a cross-currency ineres rae swap where he counerpary will receive or pay ineres a 6-monh dollar LIBOR. 8

9 Comparison wih forward conracs Forward exchange conrac involves an agreemen now for he sale or purchase of a quaniy of one currency in exchange for anoher currency a a specified fuure dae. The rae of exchange is he spo adjused for he ineres rae differenial beween he wo currencies over he period of he forward conrac ineres rae pariy relaion. How currency swaps differ from ourigh forward conracs? There is ofen an exchange of principal a iniiaion. Ineres usually is exchanged a regular inervals during he swap period. The regular exchange of ineres means ha he re-exchange of principal a mauriy can be a oday s spo rae. The period of a swap is longer han ha for mos forward conracs. 9

10 Arranging finance in differen currencies The company issuing he bonds can use a currency swap o issue deb in one currency and hen swap he proceeds ino he currency i desires. Three specific purposes To obain lower cos funds. Suppose here is a srong demand for invesmens in currency A a company seeking o borrow in currency B could issue bonds in currency A a a low rae of ineres and swap hem ino he desired currency B. To gain access o a resriced capial marke. To obain funding in a form no oherwise available. Marke condiions migh preclude he issuance of long erm deb bearing a fixed ineres rae in Yen. 10

11 Hedging currency exposures Long erm invesmen (liabiliy) in a currency ha generaes (pays) a sream of cashflows exposure o a fall (rise) in he value of he currency. To gain access o a resriced capial marke. To obain funding in a form no oherwise available. Marke condiions migh preclude he issuance of long erm deb bearing a fixed ineres rae in Yen. Locking in a forward rae Currency swaps can be used o lock in a forward rae for a fuure foreign currency receip or paymen eiher as an alernaive o a forward exchange conrac or when a forward conrac is unobainable. 11

12 Asse currency swaps A Briish company has difficulies o raise capial in Pounds bu here exis US asse fund managers who are willing o buy bonds in US dollars issued by he Briish company. By enering ino a currency swap wih a bank he Briish company can raise he Pounds ha i wans. 12

13 Iniiaion: US asse funds issue bond in US dollars US 15 millions Briish company Inermediae ineres paymens: Pound 10 millions US 15 millions bank US asse funds coupon paymen o bond holders Briish company ineres paymens in Briish pounds ineres paymens in US dollars bank Mauriy of bond and swap: US asse funds US 15 millions (expiraion of US bond) Briish company US 15 millions Pound 10 millions bank 13

14 Basis swaps Basis swaps involve swapping one floaing index rae for anoher. Banks may need o use basis swaps o arrange a currency swap for he cusomers. Example A cusomer wans o arrange a swap in which he pays fixed dollars and receives fixed serling. The bank migh arrange 3 oher separae swap ransacions: an ineres rae swap fixed rae agains floaing rae in dollars an ineres rae swap fixed serling agains floaing serling a currency basis swap floaing dollars agains floaing serling 14

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16 Hedging he bank s risk Exposures arise from mismach in daes and amouns of paymens. Hedging mehods If he bank is paying (receiving) a fixed rae on a swap i could buy (sell) governmen bonds as a hedge. If he bank is paying (receiving) a variable rae i can hedge by lending (borrowing) in he money markes. When he bank finds a counerpary o ransac a maching swap in he opposie direcion i will liquidae is hedge. 16

17 Muli-legged swaps In a muli-legged swap a bank avoids aking on any currency risk iself by arranging hree or more swaps wih differen cliens in order o mach currencies and amouns. Example A company wishes o arrange a swap in which i receives floaing rae ineres on Ausralian dollars and pays fixed ineres on serling. a fixed serling versus floaing Ausralian dollar swap wih he company a floaing Ausralian dollar versus floaing dollar swap wih counerpary A a fixed serling versus dollar swap wih counerpary B 17

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19 Amorizing swaps The principal amoun is reduced progressively by a series of reexchanging during he life of he swap o mach he amorizaion schedule of he underlying ransacion. Example A company has an ousanding dollar loan ha is being paid off gradually over 3 years. The company would like o swap his dollar liabiliy ino a serling liabiliy. An exchange of principal a iniiaion receives serling in exchange for dollars. An annual re-exchange of par of he principal amoun receives sufficien dollars each year o mee he repaymen schedule on is loan. Regular exchanges of ineres. 19

20 Semi-fixed swap wih a FOREX rigger The buyer links is forex and ineres rae exposures and produces an inegraed hedge. Hedging he various underlying exposures separaely ofen resuls in higher hedging coss as he company is likely o be over hedged. Example The swap rae is 5% he company would pay a lower rae such as 4.5% when he DM is above a rigger of DM 1.75 o he US dollar; a higher rae such as 6.5% when he DM is below he rigger. The hree parameers in his srucure makes he produc more flexible han plain vanilla swaps. 20

21 THB/USD Gradual Annuiy Swap Counerparies: Goldman Sachs Capial Markes L.P. Counerpary Mauriy Dae: 5 years from he Effecive Dae USD Noional Amoun: Amorizing as per USD Noional Schedule THB Noional Amoun: Amorizing as per THB Noional Schedule Iniial Principal Exchange: None Principal Exchanges: On each Principal Exchange Dae as per he Noional Schedule: Counerpary pays THB Amorizaion Amoun GSCM pays USD Amorizaion Amoun Ineres Period: Semi-annual Ac/360 from he Effecive Dae 21

22 Period Paymens: If MAX < Counerpary pays 4.90% If MAX > Counerpary pays 9.90% Oherwise Counerpary pays 4.90% (MAX 45.00)% on USD Noional Amoun MAX: Maximum rade of THB/USD during he semi-annual Ineres Period as deermined by Calculaion Agen Business Days: New York London and Bangkok Example: If Maximum rade of THB/USD during a semiannual period is hen coupon for ha period is * 7.00% = 8.40% 22

23 Differenial Swap (Quano Swap) A special ype of floaing-agains-floaing currency swap ha does no involve any exchange of principal no even a mauriy. The noional principal amoun is in jus one currency. Ineres paymens are exchanged by reference o a floaing rae index in one currency and a floaing rae index in a second currency. Boh ineres raes are applied o he same noional principal. Ineres paymens are made in he same currency as he noional principal amoun. 23

24 A simple example of differenial swap The semi-annual ineres sreams will be paid in dollars. six-monh dollar LIBOR of 5.25% plus margin (rese every 6 monhs) six-monh DM LIBOR of 6.75% (rese every 6 monhs) noional principal = $10 (million) swap counerpary US LIBOR + margin (say 40 basis poins) bank swap counerpary DM LIBOR bank 24

25 Uses of differenial swaps The diff swap requires he swap dealer o pay DEM LIBOR plus 1.85 percen in exchange for Serling LIBOR wih boh raes ranslaed ino cash flows using he same GBP 10 million noional principal. The enor of his agreemen which specified quarerly selemens was wo years. 25

26 Quesion Assuming ha he swap dealer has lef his posiion unhedged wha is he implici view he is aking wih respec o rae changes in he Unied Kingdom and Germany? Answer The dealer is implicily assuming ha he differenial beween he Briish and German shor-erm raes will widen more rapidly and by a greaer amoun han he curren marke view. Eiher he German raes fall as Briish raes rise or Serling LIBOR rises a an acceleraed pace relaive o DM LIBOR. 26

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28 Given ha he presen pound and DM LIBOR differenial (i.e. 110bps = 6.25% %) is less han he 185-basis-poin swap spread differenial he will be required o make he firs ne selemen paymen. Suppose ha bid-ask fixed raes on woyear serling-denominaed plain vanilla swaps (agains hreemonh serling LIBOR) are currenly being quoed in he inerbank marke a 8.00% and 8.05% respecively. Quesions Wha combinaion of ransacions would be needed o ransform he diff swap ino a conrac by which he dealer receives a cash flow of he form (consan percen DM LIBOR) and pays serling LIBOR? Afer he ransacions is i consisen wih he implied view proposed earlier? 28

29 Answers The desired ransformaion could be made by combining a pay-dm LIBOR / receive-serling LIBOR diff swap posiion wih wo receive-8.00% fixed/pay-serling LIBOR swaps (or one for wice he GBP 10 million principal). Noice ha he dealer s iniial ne cash flow on he combined ransacion is now posiive wih value equals 2.75% [obained as (14.15% %) 6.25%]. Alhough he dealer sill benefis from a German or Briish rae decline an increase in eiher rae - regardless of he size of he differenial beween hem will erode his advanage. Thus he new posiion creaes a markedly differen exposure for he dealer han did he original diff swap. 29

30 Hedging of differenial swap A clien of he Bank has exising borrowings in serling paying floaing rae ineres linked o serling LIBOR. The clien would like o pay he lower ineres rae available on he dollar bu does no wan currency exposure o he dollar. dollars Serling 3 monhs LIBOR 3% 9% 5 years fixed 8% 7% The clien eners a diff swap wih he Bank paying $LIBOR paid in serling (rae of 1.50) and receiving Serling LIBOR. 30

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32 Bank s viewpoin on he srucure The bank need o ake wo offseing swaps wih wo oher paries. An ineres rae swap fixed rae of 8% agains floaing LIBOR in dollars (noional principal of 150m dollars). An ineres rae swap fixed rae of 7% agains floaing LIBOR in Serling (noional principal of 100m Pounds). The bank is exposed o changes in he dollar / serling exchange rae (need o ake measures o hedge such posiions). Pricing for a differenial swap The ne difference in swap raes of he currencies involved plus he cos of hedging he bank s currency risk. 32

33 Pricing of currency swaps The swap raes are se such ha he value of currency swap a iniiaion is zero. The swap value a a fuure dae depends on he ineres raes in he wo currencies r d and r f and he foreign exchange rae F. X k 1 X X k k 2 3 X k n iniial dae value dae n X X j2 j3 j 1 X X j n The paymen daes for he swap cash flows are 1 2 n. 33

34 34 Le V j be he swap value in currency j a ime is he discoun facor a ime for mauriy i in currency h h = j k. i h B F j k is he spo exchange rae he price in erms of currency j of currency k a ime. [ ] [ ] n n n n j j j j j j k j k k k k k k j B X B X B X F B X B X B X V = L L The valuaion involves discouning he fuure cash flow sreams in he wo currencies.