International-Financial-Management---Bekaert-2e---Solutions---Ch21.doc

International-Financial-Management---Bekaert-2e---Solutions---Ch21.doc

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9

Chapter21:

InterestRateandForeignCurrencySwaps

Chapter 21

InterestRateandForeignCurrencySwaps

QUESTIONS

1.Howdoesaninterestrateswapwork?

Inparticular,whatisthenotionalprincipal?

Answer:

AninterestrateswapisanagreementbetweencounterpartiesthatallowsanMNCtochangethenatureofitsdebtfromafixedinterestratetoafloatinginterestrateorfromafloatinginterestratetoafixedinterestrate.Onecounterpartytothebasicinterestrateswappaysafixedamountofinterestonanotionalprincipaltotheothercounterparty,whichinturnispayingthefloatinginterestratecashflowsonthesamenotionalamounttothefirstcounterparty.Thetermnotionalindicatesthebasicprincipalamountonwhichthecashflowsoftheinterestrateswapdepend.Unlikeacurrencyswap,noexchangeofprincipalisnecessarybecausetheprincipalisanequalamountofthesamecurrency.Usually,onlyanetinterestpaymentismadedependinguponwhetherthefixedinterestratestatedintheswapishigherorlowerthanthefloatinginterestrate.

2.Whatisacurrencyswap?

Describethestructureofandrationaleforitscashflows.

Answer:

Acurrencyswapisessentiallyanagreementbetweentwopartiestoexchangethecashflowsoftwolong-termbondsdenominatedindifferentcurrencies.Thepartiesexchangeinitialprincipalamountsinthetwocurrenciesthatareequivalentinvaluewhenevaluatedatthespotexchangerate.Simultaneously,thepartiesagreetopayinterestonthecurrencytheyinitiallyreceive,toreceiveinterestonthecurrencytheyinitiallypay,andtoreversetheexchangeofprincipalamountsatafixedfuturedate.

3.Whatisacreditdefaultswap?

Whathappensintheeventofdefault?

Answer:

Acreditdefaultswapisessentiallyabilateralinsurancecontractbetweenaprotectionbuyerandaprotectionsellertoprotectagainstdefaultonaspecificbondorloanissuedbyacorporationorsovereign（the“referenceentity”）.Theprotectionbuyerpayssemi-annualorannualinsurancepremiumstotheprotectionseller.Inreturn,whenthereisadefaultevent,theprotectionsellertransfersvaluetotheprotectionbuyer.Valueistransferredeitherthroughphysicalsettlementorcashsettlement.Ifthereisphysicalsettlement,theprotectionbuyerdeliversthedefaultedbondtotheprotectionsellerwhopaysthefaceamountofthereferencedbond.Ifthereiscashsettlement,theprotectionsellerpaysthebuyerthedifferencebetweenthefacevalueofthebondandthevalueofthedefaultedbond.

4.Banksquoteinterestrateandcurrencyswapsusingthe6-monthLIBORasabasisforbothtransactions.Howcanabankmakemoneyifitdoesnotspeculateonmovementsineitherinterestratesorexchangerates?

Answer:

Banksquotethefixedsideoftheswapwithabid-askspread.Whentheypaythefixed-ratesideoftheswap,theydosoatalowerratethanwhentheyreceivethefixed-ratesideoftheswapfromtheircounterparty.Thus,iftheyareabletobalancethetransactions,beingbothapayerofthefixedrateandareceiverofthefixedrateforthesamegrossamounts,theyearnthebid-askspread.Thiscanbeasubstantialamountofmoney.

5.WhatistheAICofabondissue?

Answer:

Theall-incost（AIC）ofabondissueistheinternalrateofreturnthatequatesthepresentvalueofallthefutureinterestandprincipalpaymentstothenetproceeds（facevalueminusfees）receivedbytheissuer.

6.Whatisacomparativeadvantageinborrowing,andhowcoulditarise?

Answer:

Comparativeadvantageinborrowingmeansthattheratiooftheborrowingcostinonecurrency（oneplustheinterestrate）totheborrowingcostsinanothercurrencyisnotthesamefortwocompanies.Thecompanywiththelowerratiohasacomparativeadvantageinborrowingthenumeratorcurrencyeventhoughitsabsoluteborrowingcostsmaybehigherthantheothercompany’scostsineachcurrency.Suchdifferencesimplythatthecompaniesshouldborrowinthecurrencyinwhichtheyhaveacomparativeadvantage,andswapintothecurrencyofchoicebasedonotherconsiderationssuchasforeignexchangerisk.

Comparativeborrowingadvantagesarisebecauseinstitutionaldifferencesacrosscountriesleadtodebtpricingthatisslightlydifferent,dependingontheultimateholderofthedebtanditscurrencyofdenomination.Someofthesepricingdifferencesareduetothedifferentwayscreditrisksareanalyzedaroundtheworld.Essentially,thesedifferencesamounttoamarketinefficiencythatcanbeexploitedforprofit.Theresultisthatsomecompaniescanmoreeasilyissuedebtinsomecurrenciesthaninothercurrencies.

7.Whatisbasispointadjustment?

Whyisitnotappropriatesimplytoaddthebasispointdifferentialassociatedwiththefirstcurrencytothequotedswapratethatthefirmwillpay?

Answer:

Ifacustomerwantsthefinancialintermediarytodoacurrencyswapinwhichthefinancialintermediarywillpaytheinterestandprincipalonthecustomer’soutstandingbond,whichhasaninterestratethatisdifferentfromtheinterestratethattheintermediaryisquoting,thefinancialintermediarywillalsohavetoadjustthebasispointsonthecashflowsofthecurrencyintheswapthatthecustomerispaying.Onecannotsimplyaddtheadditionalbasispointsthatthefinancialintermediaryispayingtotheratethatthecustomerwillpay,ifthelevelsoftheinterestratesonthetwocurrenciesaredifferent,becauseabasispointinthefutureforacurrencythatisdepreciatinginvalueisworthlessthanabasispointinthefutureforacurrencythatisappreciatinginvalue.Thecorrectprocedurerequiresthatonetakethepresentvalueoftheextrainterestratepaymentsthatthefinancialintermediaryispayinginonecurrency,convertthatamountintothecurrencythatthecustomerispayingwiththespotexchangerate,anddeterminetheadditionallevelpaymentsofthenewcurrencythatwouldhavethatpresentvalue.

8.Discussthesenseinwhicha5-yearcurrencyswapisasequenceoflong-termforwardcontracts.Howdotheimplicitforwardexchangeratesinacurrencyswapdifferfromthelong-termforwardexchangeratesforthosematurities?

Answer:

A5-yearcurrencyswapisanagreementtoexchangecertainamountsoftwocurrenciesinthefuture,whichsoundsverysimilartoaforwardcontract.Unlikeforwardcontracts,though,theamountsarethesameforthefirstfouryears,equaltotheinterestontheprincipalsofthetwocurrencies.Then,inthefifthyear,theinterestandprincipalsonthetwocurrenciesareexchanged.Theprincipalswereoriginallyequalinvalueattheoriginalspotexchangerate,buttheywillgenerallynotbeequalinvalueatthefinalspotexchangerate.

9.Whatarethedeterminantsofthevalueofacurrencyswapastimeevolves?

Isitpossibletocloseoutaswapbeforeithasreachedmaturity?

Answer:

Whenaswapisinitiated,thecashflowsoftwobondsindifferentcurrenciesareagreedtobeexchanged.Thesebond-likecashflowshavethesamepresentvalueatthecurrentspotexchangerate.Changesintheexchangerateobviouslychangethevalueofonesideoftheswapcomparedtothevalueoftheothersideoftheswap.Inaddition,increasesininterestratesdecreasethepresentvalueofcashflows,anddecreasesininterestratesincreasethepresentvalueofcashflows.Thus,changesininterestratesandexchangeratesgivecurrencyswapsvalue.Onesidewinsandtheotherloses.Itispossibletocloseoutaswapbyhavingthepartythathaslostmoneyintheswappaythisvaluetothepartythathasgainedvalueintheswap.

PROBLEMS

1.GeneralMotors（GM）wantstoswapoutof$15,000,000offixedinterestratedebtandintofloatinginterestratedebtfor3years.Supposethefixedinterestrateis8.625%andthefloatingrateisdollarLIBOR.WhatsemiannualinterestpaymentswillGMreceive,andwhatwillGMpayinreturn?

Answer:

BecauseGeneralMotorswantstoswapoutofthefixedinterestratedebtintoafloatinginterestratedebt,itwillreceivethefixedinterestratesideoftheswap,anditwouldpaythesemi-annualLIBOR.Thus,itwouldreceive6semiannualpaymentsof

0.5×0.08625×$15million=$646,875

Thesepaymentswouldbefixedfor5years.

FinancialInstitution

GeneralMotors

TimePeriod

PaystheFixedRate

ReceivestheFloatingRate

ReceivestheFixedRate

PaystheFloatingRate

Year0.5

（$646,875）

LIBOR/2x$15mill

$646,875

（LIBOR/2x$15mill）

Year1.0

（$646,875）

LIBOR/2x$15mill

$646,875

（LIBOR/2x$15mill）

Year1.5

（$646,875）

LIBOR/2x$15mill

$646,875

（LIBOR/2x$15mill）

Year2.0

（$646,875）

LIBOR/2x$15mill

$646,875

（LIBOR/2x$15mill）

Year2.5

（$646,875）

LIBOR/2x$15mill

$646,875

（LIBOR/2x$15mill）

Year3.0

（$646,875）

LIBOR/2x$15mill

$646,875

（LIBOR/2x$15mill）

Becausethecurrencyisthesame,onlyanetinterestpaymentisactuallytransferredbetweenthetwoparties.Thatis,thepartywiththehigherinterestratepaysthenetinterestpaymenttothepartywiththelowerinterestrate.

2.PfizerisaU.S.firmwithconsiderableeuroassets.Itisconsideringenteringintoacurrencyswapinvolving$10millionofitsdollardebtforanequivalentamountofeurodebt.Supposethematurityoftheswapis8years,andtheinterestrateonPfizer’soutstanding8-yeardollardebtis11%.Theinterestrateontheeurodebtis9%.Thecurrentspotexchangerateis$1.35/€.Howcouldaswapbestructured?

Answer:

Pfizerwantstoswapoutof$10millionofdollardebtthathasan11%interestrateandtoswapintoanequivalentamountofeuro-denominateddebtthatwillrequirepaymentsof9%per