1 / 23

Swaps

Swaps. Add a swap to a loan to change loan’s type Plain vanilla interest rate swap – domestic currency denominated but involving different loan structures, fixed vs. floating rate loans Plain deal foreign currency swap – same loan structure, fixed interest rate, but different currencies.

crete
Download Presentation

Swaps

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Swaps • Add a swap to a loan to change loan’s type • Plain vanilla interest rate swap – domestic currency denominated but involving different loan structures, fixed vs. floating rate loans • Plain deal foreign currency swap – same loan structure, fixed interest rate, but different currencies.

  2. Interest Rate Swap • Swap interpretation: investing in one type and financing in another type • Types = fixed versus floating rate • Coy. B, due to higher credit rating, has an absolute advantage in both types

  3. Plain Vanilla Interest Rate Swap • Coy. B has comparative advantage in fixed rate, interest advantage is greater • Coy. A has comparative advantage in floating rate!!, interest disadvantage is less • Coys. A and B, each has a comparative advantage in the type of loan each does not desire • Preconditions of a viable swap

  4. Interest Rate Swap • Page 2 depicts a specific swap • Other swaps are possible: triangular region specified by the 3 inequalities on page 3 • On border of triangle, one party does not gain; on vertex, two parties do not gain • Gain = 65 basis points for all swaps

  5. FX Swap • Canuck Avions de Ligne, Ltée Case • Comparative advantage requirement for a viable swap is satisfied • CAL has comparative advantage in real, Garota has comparative advantage in C$ • But CAL wants C$, Garota wants reais • Add FX swap to financing in one currency; result: financing in the other currency

  6. FX Swap • Interpretation: A portfolio (5-pack) of forward contracts with different maturities • CAL buys real forward to hedge real loan • Garota buys C$ forward to hedge C$ loan • Implied forward rate common to all 5 maturities is BR7.824/C$ vs. spot rate of BR7.366/C$, qualitatively consistent with IRP.

  7. FX Swap Effects • Garota obtains real financing at its prespecified required rate of 15%, this built into swap cash flow calculations • CAL obtains C$ financing at 9.61%, calculated using the Excel’s IRR function • CAL reduces its C$ financing cost by 89 basis points

  8. Viñas de Valdivia, SA • Determine the reference currency (Chilean peso) cost of financing in another currency (U$) via ex-post Uncovered Interest Parity • Technique applies only to purediscount loan arrangement • UIP: (1+ KU$) = (1+10%)(1+a) where KU$ is the Chilean peso cost of U$ financing and a is the annual appreciation of U$

  9. Viñas de Valdivia, SA • Construct sensitivity analysis graph: gauge sensitivity of Chilean peso cost to a • Breakeven value of a is 36.36%, where the peso costs are equalized • At projected a, peso debt is cheaper • Better to borrow at 50% than at 10%!!!! • 10% in U$’s is 65% in Chilean pesos.

  10. Bling-Bling Corporation • Must use IRR function, cannot use ex-post Uncovered Interest Parity, since loan not pure discount arrangement • Complication: issue costs • Issue cost % applies to the gross financing • Gross-up the net financing

  11. Bling-Bling Corporation • Yen cash flows must be forward hedged • FX loan: sell loan proceeds at Bid, buy debt service at Ask • Criterion: Minimize cost of financing in the reference currency (U$) • Technique: determine vector of U$ cash flows, then apply IRR function

  12. Hedging FX financing cash flows • Canuck Avions case: one swap. • Bling-Bling case: five forward contracts • Bling-Bling must buy JY288,659,794 forward for years 1, 2, 3, 4, 5 and JY7,216,494,880 for year 5. • Valid comparison of reference currency vs. FX financing requires that the latter be fully hedged

  13. Principal Repayment Arrangements • 0. Zero-Coupon-type: only 1 debt service date. • 1. Bond-type: pay only interest; at maturity repay entire principal. • 2. Mortgage-type: fully amortized with equal annual debt service (blend of interest and principal repayment). • 3. Type-3: Principal repaid in equal annual installments; debt service declines during loan life. • Ranked from fastest to slowest pace of principal repayment: 3, 2, 1, 0. The higher the number, the faster the pace of principal repayment.

  14. Equal annual repayment of principal (type 3 loan) • Borrow $1 at 10% over two years. • Principal repayment = 0.5 per year. • Interest payments: year1 = $1 x 10% = .1; year2 = $.5 x 10% = .05 • Debt service: year1 = .5 + .1 = .6; year2 = .5 + .05 = .55 • Cash flows: 1; -.6; -.55. IRR = 10%

  15. Tabular format for type 3 loan

  16. Pure discount or zero coupon loan • Net = $100, F = 5%, interest rate = 10%, maturity = 3 years, Gross = $100 / (1-.05) = $105.26 • Debt service occurs at only one point in time, end of year 3 (loan’s maturity) • Debt service = 105.26(1.1)^3 =140.10 • Initial financing reflects Net • Debt service reflects Gross • Cash flows: 100, 0, 0, -140.10 • All-in Cost = 11.9%

  17. Effect of up-front fee on pace of principal repayment to minimize all-in cost • Borrow $1 over 2 years: 10% interest rate, 5% up-front fee • Grossed-up principal = 1.05263 = 1/(1-.05) • Mortgage-type loan: 1; -0.6065; -0.6065 implies cost = 13.9% • Pure-discount bond: 1; 0 ; -1.27368 implies cost = 12.86% • Choose slow pace of principal repayment to amortize up-front loan processing fee over longer effective time horizon (or bond duration). • The faster the pace of principal repayment (other things equal), the higher the all-in cost.

  18. No interest loan! (but loan processing fee charged) • F=5%: need Net=$100, Gross= $105.26 • If pay @ end year 1: Cost = 5.26% since cash flows are 100, -105.26 • If pay @ end year 2: Cost = 2.6% since cash flows are 100, 0, -105.26 • Moral of the story: If incur up-front loan processing fee, choose longest maturity possible.

  19. Effects of loan processing fee (F) and FX-denomination

  20. Financing in FX and incur up-front processing fee • If FX is projected to depreciate or exhibits a forward discount, repay principal slowly, other things equal. Unambiguous: Go slooow bro! • If FX is projected to appreciate or exhibits a forward premium, the two loan facets have contradictory effects. Ambiguous: Dunno bro! • Two loan facets: financing in an FX and incur processing fee up-front.

  21. Covered/Uncovered Interest Parity: Implications • High interest rate currency trades at a forward discount and will depreciate. • Low interest rate currency trades at a forward premium and will appreciate. • The two effects work at cross purposes: one raises, the other lowers the cost of financing in the reference currency. • Implication: Apply Excel’s IRR function!

  22. Dubious Rules of Thumb • Definitions: soft currency, likely to depreciate; hard currency, likely to appreciate. • Always finance in a soft currency. Problem: such a currency exhibits high interest rate. • Always finance in a low interest currency. Problem: such a currency will likely appreciate. Low interest currencies are hard.

  23. Attaching FX Derivatives • An arbitrage play: firm seeking financing must be able to sell the FX derivative at a higher price than that at which it buys the same FX derivative • Financial institutions must face regulatory restrictions which preclude them from direct purchase of the FX derivative • Dual currency or currency option bonds circumvent restrictions

More Related