Chapter 21: Interest Rate and Foreign
Currency Swaps
Power Points created by:
Joseph F. Greco Ph. D.
California State University, Fullerton
Mihaylo College of Business and Economics
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Chapter 21: Interest Rate and Foreign
Currency Swaps
21.1
Introduction to Swaps
21.2
Interest Rate Swaps
21.3
Foreign Currency Swaps
21.4
Parallel Loans and Back-to-Back Loans
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21.1 Introduction to Swaps
Introduction to Swaps: Overview
• Introduction
• Currency Swaps Versus Interest Rate Swaps
• The Size of the Swap Markets
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21.1 Introduction to Swaps
• Introduction
• Swaps
• International Swap and Derivatives Association
(ISDA)
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21.1 Introduction to Swaps
• Currency Swaps Versus Interest Rate Swaps
• Currency swap
• Interest rate swap
• Notional principal
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Exhibit 21.1
Foreign Currency Swap Diagram
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Exhibit 21.2
Interest Rate Swap Diagram
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21.1 Introduction to Swaps
• The Size of the Swap Markets
• Phenomenal growth since 1980’s
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Exhibit 21.3
The Size and Growth of Interest Rate and Currency Swap
Markets (Amounts oustanding in billions of U.S. dollars)
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21.2 Interest Rate Swaps
Interest Rate Swaps: Overview
• Interest Rate Risk
• The Nature of Interest Rate Swap Contracts
• The Profitability of Interest Rate Swaps
• Dealing with Credit Risks: Requiring Collateral and
Marking to Market
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21.2 Interest Rate Swaps
• Interest Rate Risk
• Fixed vs. floating-rate debt
• Changed circumstances
• Views on the future
• Minimizing the cost of debt
• Manipulating earnings
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21.2 Interest Rate Swaps
• The Nature of Interest Rate Swap Contracts
• Swap spread
• The bank’s fixed bid and offer interest rates
• Notional principal
• Amount of outstanding debt
• Bid-ask prices for interest rate swaps
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21.2 Interest Rate Swaps
• The Profitability of Interest Rate Swaps
• To make the bid-ask spread, bank must
• Match the total amount of swaps for a given
maturity with the total principal amounts
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21.2 Interest Rate Swaps
• Dealing with Credit Risks: Requiring Collateral and
Marking to Market
• The Bank’s Credit Risk
• To provide triple A credit rating, banks create
subsidiaries who specialize in conducting
swap transactions
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21.3 Foreign Currency Swaps
Foreign Currency Swaps: Overview
• The Mechanics of Modern Currency Swaps
• Comparative Borrowing Advantages in Matched
Currency Swaps
• Swapping Bond Proceeds and Coupon Rates with
Quoted Swap Rates
• Currency Swaps as a Package of Forward Contracts
• The Value of a Currency Swap
• The Rationale for Currency Swaps
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Exhibit 21.5
The Cash Flows of a Currency Swap
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21.3 Foreign Currency Swaps
• The Mechanics of Modern Currency Swaps
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Exhibit 21.6
The Cash Flows for Floyds from a Currency Swap
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21.3 Foreign Currency Swaps
• Comparative Borrowing Advantages in Matched
Currency Swaps
• The Goodweek-Bridgerock Situation
• Absolute vs. competitive advantage
• Absolute borrowing advantage
• Comparative borrowing advantage
• Using a financial intermediary in a currency
swap
• The sources of the gains from a swap
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Exhibit 21.7
Possible Bond Issues for Goodweek and Bridgerock
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Exhibit 21.8
Swaps with Bank Carribus as the Financial
Intermediary
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Exhibit 21.9
Intermediated Currency Swap Diagram
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Exhibit 21.10
The Gains from Swapping
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21.3 Foreign Currency Swaps
• Swapping Bond Proceeds and Coupon Rates with
Quoted Swap Rates
• The Transactions of Goodweek
• Basis point adjustment
• Deriving the basis point adjustment
• The Transaction of Bridgerock
• The Transaction of Bank Carribus
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Exhibit 21.11
Swaps as Individual Transactions at Quoted Rates
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21.3Foreign Currency Swaps
• Currency Swaps as a Package of Forward
Contracts
– Euro Bond Issues with Forward Hedging
• The Value of a Currency Swap
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Exhibit 21.12
Bond Issues Hedged in the Forward Market
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Exhibit 21.13
Valuing a Swap to Close Out the Position
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21.3 Foreign Currency Swaps
• The Rationale for Currency Swaps
• Why swaps and not forwards?
• Long term forwards grow more expensive as
term increases due to widening of bid-ask
spread
• Banks like swaps because the can easily
hedge the swap with bonds
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21.4 Parallel Loans and Back-to-Back Loans
Parallel and Back-to-Back Loans: Overview
• Parallel Loans
• Back-to-Back Loans
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21.4 Parallel Loans and Back-to-Back Loans
• Parallel Loans:
• A situation in which two corporations have
headquarters in two different countries.
• Each makes a loan of equivalent value to the
subsidiary of the other company that operates in
its country.
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Exhibit 21.14
Parallel Loan Diagram
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21.4 Parallel Loans and Back-to-Back Loans
• Topping-up Clauses:
• Requirements in debt contracts that additional
advances or repayment of principal occur under
specified conditions, usually triggered by an
exchange rate crossing a preset barrier
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21.4 Parallel Loans and Back-to-Back Loans
• Back-to-Back Loans:
• An agreement that is similar in structure to a
parallel loan.
• Loans are made between MNC parent
corporations
• They in turn lend to their subsidiaries in two
different countries and contain right of offset
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Exhibit 21.15
Back-to-Back Loan Diagram
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21.4 Parallel Loans and Back-to-Back Loans
• Right of offset:
• A clause which stipulates that if one party defaults
on a payment, the other can withhold
corresponding payments
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