Chapter 14

Interest Rate & Currency Swaps

Prepared by Shafiq Jadallah

To Accompany
Fundamentals of Multinational Finance
Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman
Copyright © 2003 Pearson Education, Inc. Slide 14-1
 Trident Corporation:
Swapping to Fixed Rates
 Maria Gonzalez (Trident’s CFO) is concerned about
the floating rate loan
• Maria thinks that rates will rise over the life of the loan
and wants to protect Trident from an increased interest
payment
• Maria believes that an interest rate swap to pay
fixed/receive floating would be Trident’s best
alternative
• Maria contacts the bank and receives a quote of 5.75%
against LIBOR; this means that Trident will receive
LIBOR and pay out 5.75% for the three years

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 Trident Corporation:
Swapping to Fixed Rates
 The swap does not replace the original loan, Trident
must still make its payments at the original rates; the
swap only supplements the loan payments
 Trident’s 1.50% fixed rate above LIBOR must still be
paid along with the 5.75% as per the swap agreement;
however, Trident now receives LIBOR thus offsetting
the floating rate risk in the original loan
 Trident’s total payment will therefore be 7.25%
(5.75% + 1.50%)

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 Trident Corporation:
Swapping to Fixed Rates

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 Trident Corp:
Swapping Dollars into Swiss francs
 After raising the $10 million in floating rate financing
and swapping into fixed rate payments, Trident
decides it would prefer to make its debt-service
payments in Swiss francs
• Trident signed a 3-year contract with a Swiss buyer,
thus providing a stream of cash flows in Swiss francs
 Trident would now enter into a three-year pay Swiss
francs and receive US dollars currency swap
• Both interest rates are fixed
• Trident will pay 2.01% (ask rate) fixed Sfr interest and
receive 5.56% (bid rate) fixed US dollars
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 Trident Corp:
Swapping Dollars into Swiss francs

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 Trident Corp:
Swapping Dollars into Swiss francs
 The spot rate in effect on the date of the agreement
establishes what the notional principal is in the target
currency
• In this case, Trident is swapping into francs, at
Sfr1.50/$.
• This is a notional amount of Sfr15,000,000. Thus
Trident is committing to payments of Sfr301,500 (2.01%
 Sfr15,000,000 = Sfr301,500)
• Unlike an interest rate swap, the notional amounts are
part of the swap agreement
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 Trident Corp:
Swapping Dollars into Swiss francs

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 Trident Corporation:
Unwinding Swaps
 As with the original loan agreement, a swap can be
entered or unwound if viewpoints change or other
developments occur
 Assume that the three-year contract with the Swiss
buyer terminates after one year, Trident no longer
needs the currency swap
 Unwinding a currency swap requires the discounting
of the remaining cash flows under the swap
agreement at current interest rates then converting the
target currency back to the home currency
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 Trident Corporation:
Unwinding Swaps
 If Trident has two payments of Sfr301,500 and
Sfr15,301,500 remaining (interest plus principal in
year three) and the 2 year fixed rate for francs is now
2.00%, the PV of Trident’s commitment is francs is

Sfr301,500 Sfr15,301, 500

PV(Sfr)  1
 2
 Sfr15,002, 912
(1.020) (1.020)

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 Trident Corporation:
Unwinding Swaps
 At the same time, the PV of the remaining cash flows
on the dollar-side of the swap is determined using the
current 2 year fixed dollar rate which is now 5.50%

$556,000 $10,556,000
PV(US$)  1
 2
 $10,011,078
(1.055) (1.055)

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 Trident Corporation:
Unwinding Swaps
 Trident’s currency swap, if unwound now, would
yield a PV of net inflows of $10,011,078 and a PV of
net outflows of Sfr15,002,912. If the current spot rate
is Sfr1.4650/$ the net settlement of the swap is
Sfr15,002, 912
Settlement  $10,011,078   ($229,818)
Sfr1.4650/ $
 Trident makes a cash payment to the swap dealer of
$229,818 to terminate the swap
• Trident lost on the swap due to franc appreciation
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 Counterparty Risk
 Counterparty Risk is the potential exposure any
individual firm bears that the second party to any
financial contract will be unable to fulfill its obligations
 A firm entering into a swap agreement retains the
ultimate responsibility for its debt-service
 In the event that a swap counterpart defaults, the
payments would cease and the losses associated with
the failed swap would be mitigated
 The real exposure in a swap is not the total notional
principal but the mark-to-market value of the
differentials

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 A Three-way Cross Currency Swap
 Sometimes firms enter into loan agreements with a
swap already in mind, thus creating a debt issuance
coupled with a swap from its inception
• Example: the Finnish Export Credit agency (FEC), the
Province of Ontario, Canada and the Inter-American
Development Bank (IADB) all possessed access to
ready sources capital but wished debt service in
another market
• FEC had not raised capital in Canadian dollar
Euromarkets and an issuance would be well received;
however the FEC had a need for increased debt-service
in US dollars, not Canadian dollars

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 A Three-way Cross Currency Swap
• Province of Ontario needed Canadian dollars but due
to size of provincial borrowings knew that issues
would push up its cost of funds; there was however an
attractive market in US dollars
• IADB had a need for additional US dollar
denominated debt-service; however it already raised
most of its debt in the US markets but was a welcome
newcomer in the Canadian dollar market
 Each borrower determined its initial debt amounts
and maturities expressly with the needs of the swap

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 A Three-way Cross Currency Swap

C$300 Province of Ontario C$150

million (Canada) million
$260 $130
million million
Borrows $390 million
at US Treasury + 48 bp

Finish Export Credit Inter-American

(Finland) Development Bank

Borrows C$300 million Borrows C$150 million

at Canadian Treasury + 47 bp at Canadian Treasury + 44 bp

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 Summary of Learning Objectives
 The single largest interest rate risk of the non-
financial firm is debt-service. The debt structure of
an MNE will possess differing maturities of debt,
different interest rates and different currency
denominations
 The increasing volatility of world interest rates,
combined with increasing use of short-term and
variable-rate notes has led many firms to actively
manage their interest rate risk

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 Summary of Learning Objectives
 The primary sources of interest rate risk to an MNE
are short-term borrowing and investing and long-term
borrowing
 The techniques and instruments used in interest rate
risk management resemble those used in currency risk
management: the old method of lending and
borrowing
 The primary instruments include forward rate
agreements (FRAs), interest rate futures, forward
swaps and interest rate swaps

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 Summary of Learning Objectives
 The interest rate and currency swap markets allow
firms that have limited access to specific currencies
and interest rate structures to gain access at relatively
low costs
 A cross currency interest rate swap allows a firm to
alter both the currency of denomination of the cash
flows but also to alter the fixed-to-floating or
floating-to-fixed interest rate structure

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