International Finance

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International Finance

• FIN456Michael Dimond

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Swap Transactions

• A swap transaction in the interbank market is the
  simultaneous purchase and sale of a given amount
  of foreign exchange for two different value dates
• Both purchase and sale are conducted with the
  same counterpart
• A common type of swap is a spot against forward
• The dealer buys a currency in the spot market and
  simultaneously sells the same amount back to the
  same bank in the forward market
• Since this transaction occurs at the same time
  and with the same counterpart, the dealer incurs
  no exchange rate exposure

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Swap Transactions

• Forward-forward swaps A dealer sells 20,000
  forward for dollars for delivery in two months at
  1.8420/ and simultaneously buys 20,000 forward
  for delivery in three months at 1.8400/
• The difference between the buying and selling
  price is equivalent to the interest rate
  differential
• Thus a swap can be viewed as a technique for
  borrowing another currency on a fully
  collateralized basis

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Swap Transactions

• Non-deliverable forwards (NDFs) NDFs possess
  the same characteristics as traditional forward
  contracts except that they are settled only in US
  dollars and the foreign currency being sold or
  bought forward is not delivered
• The dollar-settlement feature reflects the fact
  that NDFs are contracted offshore and are beyond
  the reach and regulatory frameworks of the home
  country governments
• Pricing of NDFs reflects basic interest rate
  differentials

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Some Basic Interest Rates

• US Risk-free rate The yield on US Government
  bonds, set at auction. This is considered to be
  the highest return a US investor could get with
  zero default risk and is the basis for computing
  appropriate return on riskier assets.
• Federal Overnight Funds Rate The target
  interest rate set by the Federal Open-Market
  Committee (FOMC) for overnight lending and
  borrowing transactions between US banks set by
  the Federal Open-Market Committee (FOMC).
• LIBOR Average of the rates UK banks claim to be
  able to borrow from one another. LIBOR is a
  floating rate. Established in the 1980s in UK.
  This rate gets quoted based on the expected
  duration of the loan (LIBOR3 is the 3-month rate,
  LIBOR6 is the 6-month rate).
• Prime Rate This is the average base rate posted
  by the largest US banks. Fixed rate, but updated
  frequently (when 7/10 of the largest banks
  change). Since 1991, Prime has usually been
  approximately the Fed Rate 3.
• Both LIBOR Prime are used as a basis for
  commercial interest rates. For example, one might
  be able to borrow for six months at Prime1, or
  at LIBOR64
• If Prime 3.25, one could borrow at 4.25
  (Prime1)
• If LIBOR6 0.46, one could borrow at 4.46
  (LIBOR64)

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International Interest Rate Calculations
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Interest Rate Risk

• Ever increasing competition has forced financial
  managers to better manage both sides of the
  balance sheet
• All firms, domestic or multinational, are
  sensitive to interest rate movements
• The single largest interest rate risk of a
  non-financial firm is debt service (for an MNC,
  differing currencies have differing interest
  rates thus making this risk a larger concern)
• The second most prevalent source of interest rate
  risk is its holding of interest sensitive
  securities
• Can these rates be manipulated?
  http//www.ft.com/indepth/libor-scandal

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MNC Foreign Investments

• Strategic Goals
• Reduce cost to service debt
• Reduce tax burden
• Mitigate political risk
• Mitigate foreign exchange risk
• Financing vehicles include
• Interest rate swaps
• Currency swaps
• Structured notes
• Interest rate forward contracts
• Interest rate futures contracts
• International leasing
• LDC debt-equity swaps

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Credit and Repricing Risk

• Credit Risk or roll-over risk is the possibility
  that a borrowers creditworthiness at the time of
  renewing a credit, is reclassified by the lender
• This can result in higher borrowing rates, fees,
  or even denial
• Repricing risk is the risk of changes in interest
  rates charged (earned) at the time a financial
  contracts rate is being reset
• Three approaches a corporate borrower might
  employ to borrow 1MM for 3 years
• Borrow dollars for 3 years at fixed interest
  (Prime premium)
• Borrow dollars for 3 years at a floating rate
  (LIBOR premium), to be reset annually
• Borrow dollars for 1 year at a fixed rate, then
  renew credit annually

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Credit and Repricing Risk

• Approach 1 (3yr Fixed) assures itself of funding
  at a known rate for the three years what is
  sacrificed is the ability to enjoy a lower
  interest rate should rates fall over the time
  period
• Approach 2 (3yr Floating) offers what 1 didnt,
  flexibility (repricing risk). It too assures
  funding for the three years but offers repricing
  risk when LIBOR changes
• Approach 3 (1yr Fixed w/ Annual ReFi) offers
  more flexibility and more risk in the second
  year the firm faces repricing and credit risk,
  thus the funds are not guaranteed for the three
  years and neither is the price

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Interest Rate Futures

• Interest Rate futures are widely used their
  popularity stems from high liquidity of interest
  rate futures markets, simplicity in use, and the
  rather standardized interest rate exposures firms
  posses
• Traded on an exchange two most common are the
  Chicago Mercantile Exchange (CME) and the
  Chicago Board of Trade (CBOT)
• The yield is calculated from the settlement price
• Example March 03 contract with settlement price
  of 94.76 gives an annual yield of 5.24 (100
  94.76)

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Interest Rate Futures Strategies
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Interest Swaps Currency Swaps

• Swaps financial transactions in which two
  counterparties agree to exchange streams of
  payments over time
• A package of forward contracts.
• For swaps to provide a real economic benefit to
  both parties, a barrier generally must exist to
  prevent arbitrage from functioning fully, such
  as
• Legal restrictions on spot and forward foreign
  exchange transactions
• Different perceptions by investors of risk and
  creditworthiness of the two parties
• Appeal or acceptability of one borrower to a
  certain class of investor
• Tax differentials
• Swaps are contractual agreements to exchange or
  swap a series of cash flows
• An interest rate swap is an agreement between two
  parties to exchange interest payments in the same
  currency for a specific maturity on an agreed
  upon notional amount.
• A currency swap involves the exchange of
  principal plus interest payments in one currency
  for equivalent payments in another currency.
• The swap itself is not a source of capital but an
  alteration of the cash flows associated with
  payment

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Interest Rate Swaps

• If firm thought that rates would rise it would
  enter into a swap agreement to pay fixed and
  receive floating in order to protect it from
  rising debt-service payments
• If firm thought that rates would fall it would
  enter into a swap agreement to pay floating and
  receive fixed in order to take advantage of lower
  debt-service payments
• The cash flows of an interest rate swap are
  interest rates applied to a set amount of
  capital, no principal is swapped only the coupon
  payments

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Interest Rate Swap Strategies
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Currency Swaps

• Since all swap rates are derived from the yield
  curve in each major currency, the fixed-to
  floating-rate interest rate swap existing in each
  currency allows firms to swap across currencies.
• These swap rates are based on the government
  security yields in each of the individual
  currency markets, plus a credit spread applicable
  to investment grade borrowers in the respective
  markets.
• The utility of the currency swap market to a MNC
  is significant. A MNC wishing to swap a 10-year
  fixed 6.04 U.S. dollar cash flow stream could
  swap to 4.46 fixed in euro, 3.30 fixed in Swiss
  francs, or 2.07 fixed in Japanese yen. It could
  swap from fixed dollars not only to fixed rates,
  but also to floating LIBOR rates in the various
  currencies as well.

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Interest Rate and Currency Swap Quotes
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Classic Interest Swap
Can borrow at L0.5 or 8.5
Can borrow at L0.0 or 7.0
Kept 10bps
Savings Available 8.5
L0.5 7.0
L0.0 ------------
------------ 1.5
0.5 1.5 -0.5 ----------- 1.0 100 bps
Saved 65bps
Saved 25bps
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Fixed for Fixed Currency Swap
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Fixed for Fixed Example

• Suppose Dell wants to borrow 10 million for two
  years and Virgin Airlines wants to borrow 16
  million for two years, and the current (/)
  exchange rate is 1.60. Because Dell is better
  known in the United States, it can borrow on its
  own dollars at 7 percent and pounds at 9 percent,
  whereas Virgin can on its own borrow dollars at 8
  percent and pounds at 8.5
• What swap transaction would accomplish this
  objective? Assume the counterparties would
  exchange principal and interest payments with no
  rate adjustments.
• What savings are realized by Dell and Virgin?
• Suppose, in fact, that Dell can borrow dollars at
  7 percent and pounds at 9 percent, whereas Virgin
  can borrow dollars at 8.75 percent and pounds at
  9.5 percent. What range of interest rates would
  make this swap attractive to both parties?
• Based on the scenario in part (c), suppose Dell
  borrows dollars at 7 percent and Virgin borrows
  pounds at 9.5 percent. If the parties swap their
  current proceeds, with Dell paying 8.75 percent
  to Virgin for pounds and Virgin paying 7.75
  percent to Dell for dollars, what are the cost
  savings to each party?

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Fixed for Fixed Answer

• A) Virgin would borrow 10 million for two years
  and Dell would borrow 16 million for two years.
  The two companies would then swap their proceeds
  and payment streams.
• B) Assuming no interest rate adjustments, Dell
  would pay 8.5 on the 10 million and Virgin
  would pay 7 on its 16 million. Given that its
  alternative was to borrow pounds at 9, Dell
  would save 0.5 on its borrowings, or an annual
  savings of 50,000. Similarly, Virgin winds up
  paying an interest rate of 7 instead of 8 on
  its dollar borrowings, saving it 1 or 160,000
  annually.
• C) Ignoring credit risk differences, Virgin would
  have to provide Dell with a pound rate of less
  than 9. Given that Virgin has to borrow the
  pounds at 9.5, it would have to save at least
  0.5 on its dollar borrowing from Dell to make
  the swap worthwhile. If Dell borrows pounds from
  Virgin at 9 - x. then Virgin would have to
  borrow dollars from Dell at 8.75 - (0.5 x) to
  cover the 0.5 x difference between the
  interest rate at which it was borrowing pounds
  and the interest rate at which it was lending
  those pounds to Dell.
• D) Under this scenario, Dell saves 0.25 on its
  pound borrowings and earns 0.75 on the dollars
  it swaps with Virgin, for a total benefit of 1
  annually. Virgin loses 0.75 on the pounds it
  swaps with Dell and saves 1 on the dollars it
  receives from Dell, for a net savings of 0.25
  annually.

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Fixed for Floating Currency Swap
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Fixed for Floating Example

• Suppose that IBM would like to borrow fixed-rate
  yen, whereas Korea Development Bank (KDB) would
  like to borrow floating-rate dollars. IBM can
  borrow fixed-rate yen at 4.5 percent or
  floating-rate dollars at LIBOR 0.25 percent.
  KDB can borrow fixed-rate yen at 4.9 percent or
  floating-rate dollars at LIBOR 0.8 percent.
• What is the range of possible cost savings that
  IBM can realize through an interest rate/currency
  swap with KDB?
• Assuming a notional principal equivalent to 125
  million, and a current exchange rate of 105/,
  what do these possible cost savings translate
  into in yen terms?
• Redo Parts a and b assuming that the parties use
  Bank of America, which charges a fee of 8 basis
  points to arrange the swap.

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Fixed for Floating Answer

• A) The cost to each party of accessing either the
  fixed-rate yen or the floating-rate dollar market
  for a new debt issue is as follows
• Given the differences in rates between the two
  markets, the two parties can achieve a combined
  15 basis point savings through IBM borrowing
  floating-rate dollars at LIBOR 0.25 and KDB
  borrowing fixed-rate yen at 4.9 and then
  swapping the proceeds. IBM would be able to
  borrow fixed-rate yen at 4.35 if all these
  savings were passed along to it in the swap. This
  could be accomplished by IBM providing KDB with
  floating-rate dollars at LIBOR 0.25, saving
  KDB 0.55, which then passed these savings along
  to IBM by swapping the fixed-rate yen at 4.9 -
  0.55 4.35. Thus, the potential savings to IBM
  range from 0 to 0.15.
• B) At a current exchange rate of 105/, IBM's
  borrowing would equal 13,125,000,000
  (125,000,000105). A 0.15 savings on that amount
  would translate into 19,687,500 per annum
  (13,125,000,0000.0015).
• C) In this case, the potential savings from a
  swap net out to 7 basis points. If IBM realizes
  all these savings, its borrowing cost would be
  lowered to 4.43 (4.5 - 0.07). The 7 basis
  point saving would translate into an annual
  saving of 9,187,500 (13,125,000,0000.0007).

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Structured Notes

• Interest-bearing securities with interest
  payments determined by a formula set in advance
  and adjusted on specified reset dates.
• Formula can be tied to various factors, such as
  LIBOR, exchange rates, or commodity prices.
• Formula may include multiple factors, such as the
  difference between three-month dollar LIBOR and
  three-month Swiss franc LIBOR.
• Structured notes commonly include one or more
  embedded derivative elements, such as swaps,
  forwards, or options.
• They have sometimes been used in imprudent ways,
  such as Inverse Floaters used by Orange County,
  CA.

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Forward Futures Contracts

• Forward and futures contracts can be used to
  manage interest rate risk and debt service costs
  by locking in interest rates on future loans and
  deposits.
• Examples include forward forwards, forward rate
  agreements (FRAs), and Eurodollar futures.

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Forward Forwards FRAs

• Forward Forward a contract which fixes an
  interest rate today on a future loan or deposit.
• The contract specifies the interest rate, the
  principal amount of the future deposit or loan,
  and the start and ending dates of the future
  interest rate period.
• Forward forwards have been largely displaced by
  the forward Rate Agreement (FRA).
• Forward Rate Agreement (FRA) a cash-settled,
  over-the-counter forward contract which fixes an
  interest rate to be applied to a specified future
  interest period on a notional principal amount.
• Analogous to a forward foreign currency contract
  but instead of exchanging currencies, the parties
  to an FRA agree to exchange interest payments.

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FRA Example

• Ford has a 20 million Eurodollar deposit
  maturing in two months that it plans to roll over
  for a further six months. The company's treasurer
  feels that interest rates will be lower in two
  months time when rolling over the deposit.
  Suppose the current LIBOR6 is 7.875. How can
  Ford use an FRA at 7.65 from Banque Paribas to
  lock in a guaranteed six-month deposit rate when
  it rolls over its deposit in two months?
• Ford today can enter into the FRA and guarantee
  itself a six-month deposit rate in two months
  time of 7.65. Specifically, Ford will sell a "2
  x 6" FRA on LIBOR at 7.65 to Banque Paribas for
  a notional principal of 20 million. This means
  that Banque Paribas Trust has entered into a
  two-month forward contract on six-month LIBOR.
  Two months from now, if LIBOR6 is less than
  7.65, Banque Paribas will pay Ford the
  difference in interest expense. If LIBOR6 exceeds
  7.65, Ford will pay Banque Paribas the
  difference.
• If after two months, LIBOR6 has fallen to 7.5.
  How much will Ford receive/pay on its FRA? What
  will be Ford's hedged deposit rate for the next
  six-month period?
• In this case, Ford will receive from Banque
  Paribas 20,000,000 x (0.0765 - 0.075)/2
  15,000, giving it an annualized hedged deposit
  rate of 7.65 for the next six months.
• If in two months, LIBOR6 has risen to 8. How
  much will Ford receive/pay on its FRA? What will
  be Ford's hedged deposit rate for the next six
  months?
• Ford will pay Banque Paribas 20,000,000 x (0.08
  - 0.0765)/2 35,000, giving itas before an
  annualized hedged deposit rate of 7.65 for the
  next six months.

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Eurodollar Futures

• Eurodollar Future a cash-settled futures
  contract on a three month, 1,000,000 Eurodollar
  deposit that pays LIBOR.
• Eurodollar futures contracts are traded on
  various organized exchanges for March, June,
  September, and December delivery.
• Contracts are traded out to three years, with a
  high degree of liquidity out to two years.
• Eurodollar futures act like FRAs in that they
  help lock in a future interest rate and are
  settled in cash.
• Unlike FRAs, they are marked to market daily (as
  in currency futures, this means that gains and
  losses are settled in cash each day).

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International Leasing

• Cross-border or international leasing can be used
  to both defer and avoid tax.
• It can also be used to safeguard the assets of a
  multinational firm's foreign affiliates and avoid
  currency controls.

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LDC debt-equity swap

• LDC Less Developed Countries
• Typically have little industry and sometimes a
  high dependence on foreign aid
• Under a debt-equity program, a firm buys a
  country's dollar debt on the secondary loan
  market at a discount and swaps it into local
  equity.
• Such swaps create the possibility of cheap
  financing for expanding plant and retiring local
  debt in hard-pressed LDCs.