Lecture International financial management: Chapter 9 - Currency Swaps

CHAPTER NINE DEBT RATING BY MOODY’S INVESTORS SERVICE & STANDARD AND POOR’S CORPORATION GENERAL DESCRIPTION NONINVESTMENT GRADE CURRENCY SWAPS Low grade, speculator Highly speculator Substantial risk Extremely speculative Very extremely speculative Default Moody’s S&P’s Ba1 BB+ Ba2 BB Ba3 BB-B1 B+ B2 B B3 B- CCC+ Caa CCC CCC-Ca CC C C D 0 2 DEBT RATING BY MOODY’S INVESTORS SERVICE & STANDARD AND POOR’S CORPORATION SWAPS CONTRACTS: DEFINITIONS GENERAL DESCRIPTION INVESTMENT GRADE Maximum safety High quality Upper medium grade Lower medium grade Moody’s S&P’s Aaa AAA Aa1 AA+ Aa2 AA Aa3 AA-A1 A+ A2 A A3 A- Baa1 BBB+ Baa2 BBB Baa3 BBB- • In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. • There are two types of interest rate swaps: – Single currency interest rate swap • “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps. – Cross-Currency interest rate swap • This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies. 1 1 THE SWAP BANK SWAPTRANSACTION Situations confronting counterpartB before swap • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. • The swap bank 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. • A is aAAA rated bank • A is funding its loan portfolio with funds generated by Eurobond carrying an 10% Eurodollar $10 million portfolio 5 loans year maturity LIBOR A 10% Eurodollar bond $10 million loan 5 year maturity 6 AN EXAMPLE OF AN INTEREST RATE SWAP AN EXAMPLE OF AN INTEREST RATE SWAP • Consider this example of a “plain vanilla” interest rate swap. • BankAis aAAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. – BankA is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. – It would make more sense to for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. • Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. – Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. – Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent. – Firm B would prefer to borrow at a fixed rate. 2 SWAPTRANSACTION AN EXAMPLE OF AN INTEREST RATE SWAP Situations confronting counterpart A before swap • Counterpart B: BBB rated • B is a company that invests in project Eurodollar bond 11.75% $10 million portfolio 5 year maturity The swap bank makes this offer to Bank A: You pay LIBOR –8% per year on $10 million for 5 years and we will pay you 103 % on $10 million for 5 years Eurodollar loans LIBOR B LIBOR +0.5% LIBOR – 1% 8 BANKA 10 8 % 10% SWAP BANK Eurodollar Notes $100 million loan 5 year maturity Eurodollar bond 8 AN EXAMPLE OF AN INTEREST RATE SWAP The borrowing opportunities of the two firms are: COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR AN EXAMPLE OF AN INTEREST RATE SWAP ½% of $10,000,000= $50,000.That’s quite a cost savings per year for 5 SWAP years. BANK 10 3 % Here’s what’s in it for Bank A: They can borrow LIBOR – % externally at 10% fixed and have a net borrowing position of 10% BANK -10 3 + 10 + (LIBOR –1 ) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR 3 AN EXAMPLE OF AN INTEREST RATE SWAP AN EXAMPLE OF AN INTEREST RATE SWAP Fixed rate Floating rate COMPANY B BANK A 11.75% 10% LIBOR + .5% LIBOR Eurodollar bond 11.75% The swap bank makes money too. SWAP BANK 10 3 % ¼% of $10 million = $25,000 per year for 5 years. 10 ½% SWAP 10 ½% BANK LIBOR – ¼% B BANK A LIBOR +0.5% LIBOR –1 % LIBOR – ¼% LIBOR –8 – [LIBOR – ¼ ]= 1/8 COMPANY 10 ½ - 10 3 = 1/8 ¼ Eurodollar Notes COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR AN EXAMPLE OF AN INTEREST RATE SWAP AN EXAMPLE OF AN INTEREST RATE SWAP Here’s what’s in it for B: SWAP BANK ½ % of $10,000,000= $50,000 that’s quite a cost savings per year for 5 years. The swap bank makes ¼% SWAP BANK They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. 10 ½% LIBOR – ¼% COMPANY LIBOR + ½% 10 3 % LIBOR – 1 % BANK A 10 ½% LIBOR – ¼% COMPANY B COMPANY B BANK A Fixed rate 11.75% 10% A saves ½% COMPANY B B saves ½% BANK A Floating rate LIBOR + .5% LIBOR Fixed rate Floating rate 11.75% 10% LIBOR + .5% LIBOR 4 AN EXAMPLE OF A CURRENCY SWAP • Suppose a U.S. MNC (A) wants to finance a £10,000,000 expansion of a British plant. – They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds. • This will give them exchange rate risk: financing a sterling project with dollars. – They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad. AN EXAMPLE OF A CURRENCY SWAP ... - tailieumienphi.vn