bài giảng môn tài chính quốc tế interest rate swap and currency swap

 Illustrating floating rate loan case and expalining how it can be managed with forward rate agreement, interest future and interest rate swap...  Repricing risk: is the risk of chan

Introduced by

Assoc Pr Dr Truong Quang Thong

The Faculty of Banking – UEH

 Defining interest rate risk.

 Examining its management including credit risk and repricing risk.

 Illustrating floating rate loan case and expalining how it can be managed

with forward rate agreement, interest future and interest rate swap.

 Introducing currency swap case

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Interest rate risk

 All firms are sensitive to interest rate movements in one way to another.

 Debt structure of large firms are very complicated:

 Different maturities

 Different interest rate structures

 Different currencies of denomination

 Holding of interest-sensitive securities

 Marketable securities porfolio on the left-hand side of the BS.

 Representing potential earnings or interest inflows

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The Management Dilemma

 The balance of risk and return

 The role of treasury:

 Profit center?

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Credit Risk and Repricing Risk

 Credit risk or roll-over risk,

is the possibility that a borrower’s credit worthiness, at the time of renewing a credit, is reclassified by the lender.

 Repricing risk: is the risk of

changes in interest rates charged (earned) at the time

a financial contract ‘s rate is

reset.

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An example of debt strategies – The same intention to provide $1 million in

financing for 3 year period

 Strategy 1: borrow $1 million for

3 years at a fixed rate of interest.

 Strategy 2: borrow $1 million for

3 years at floating rate, LIBOR+2%, to be reset annually.

 Strategy 3: borrow $1 million for

1 year at fixed rate, then renew the credit annually.

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Loan interest rate Year 0 Year 1 Year 2 Year 3

Loan proceeds (Repayment) 9.850.000 (10.000.000)

Total Loan Cash Flows 9.850.000 (650.000) (650.000) (10.650.000)

IRR of Total Cash Flows 7.072% (AIC)

Sensitivities to Libor Libor (Y0) Libor (Y1) Libor (Y2) Libor (Y3) AIC

Carlton’s Floating Rate Case – Loan of $10 millions with 1.5% up-front fee Annual interest payment Total principal repayment at the end of 3 year period

Management Alternatives

 Refinancing

 Forward Rate Agreement (FRA)

 Interest Rate Future

 Interest Rate Swaps

Forward rate agreement (FRA)

 FRA is an interbank-traded contract to buy or sell interest rate payment on a notional principal

 The buyer obtains the right to lock in an interest rate for a desired term that begins at a future date

 The seller will pay the buyer the increased interest expense on a nominal sum (the notional principal) of money if interest rates rise above the the agreed rate, and vice versa…

Example

 The borrower wishes to lock in the first interest payment (due at the end of year 1): buy an FRA that locks in a total interest payment of 6.5%

 If LIBOR rises above 5% by the end of year 1 ?

 If LIBOR falls below 5% ?

Interest Rate Future

 Relatively widely used by high liquidity, simplicty in use

 The two most widely used future contracts:

 Eurodollar futures traded on the CME

 US Treasury Bond Futures of CBOT.

Example: Typical presentation by the WSJ Only regular quartely matutities are shown All contracts are for $1 million Points of 100%

Open interest is number of contracts outstanding

Eurodollar Futures Prices

 So, locking in an interest rate of 5.24%

 If interest rate rise by Marche 2003?

 If interest rate fall by Marche 2003?

Interest Rate Futures Strategies for Common Exposures

Exposure or Position Futures Actions Interest

Rate

Position Outcome

Paying interest on future date

Sell a future (Short position)

If rates go up

Future price fall; short earns a profit

If rates go down

Future price rises; short earns a loss

Earning interest on future date

Buy a future (Long position)

If rates go up

Future price fall; long earns a loss

If rates go down

Future price rises; long earns a profit

Interest Rate Swaps

 Swaps are contractual agreements to exchange or swap a series of cash flows commonly including interest and debt service, such as the floating rate loan.

 If to swap its fixed interest rate payment for the floating interest rate payments of another: interest swap

 If to swap currencies of debt service obligation: currency swap

 A single swap may combine element of both interest rate and currency swaps.

 Plain Vanilla Swap : agreement between tow parties to exchange fixed for floating rate financial obligation

Interest Rate Swap Strategies

floating/Receive

fixed Floating rate debt Rates to go up Pay fixed/Receive

floating

Interest Rate Swaps - Example

 Carlton ‘s existing floating rate loan is now the source

of some concerns (loan of $10 millions at Libor+2%)

 It worries that Libor may be rising in three years ahead

 It believes that a pay fixed/receive floating interest swap may be a better alternative for fixing future interest rate now

 It is quoted by a bank a fixed rate of 5.75% against Libor

Carlton’s Interest rate swap to pay fixed / receive floating

Loan interest rate Variability Year 1 Year 2 Year 3

LIBOR (floating)) Could go up or down -5.00% -5.00% -5.00%

SWAP INTEREST RATE

Receive floating Libor Could go up or down +5.00% +5.00% +5.00%

COMBINED LOAN AND SWAP POSITION

Receiving floating Libor

Currency Swap

 Motivation: to replace cash flows scheduled in

an undesired currency with flows in a desired currency.

 Utility is significant for MNSC

Currency Swap - Example

 After raising $10 million in floating rate financing and subsequently swapping into fixed rate payments, Carlton decides that it would prefer to make its debt service payment in Swiss francs.

 Carlton had recently signed a sales contract with a Swiss buyer that will be paying francs to Carlton over the next three year period.

 It wishes to match the currency of denomination of the cash flows through a currency swap.

Pay Swiss Francs and Receive US Dollars

Will receive fixed US$ at this

rate

Observation

 At the time of the Swap’s inception

 Gain or loss throughout the Swap’s life

 Nonamortizing Swap vs Unwinding Swap