Introduced by
Assoc. Pr. Dr. Truong Quang Thong
The Faculty of Banking – UEH
August 2012
INTERNATIONAL FINANCE
TÀI CHÍNH QUỐC TẾ
Lecture 7:
Interest Rate and
Currency Swaps
1
Overview

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
2
Interest rate risk

All firms are sensitive to interest rate movements in one way to
another.

Debt structure of large firms are very complicated:

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.
5
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.
6
7
Loan interest rate Year 0 Year 1 Year 2 Year 3
Libor (floating) 5.00% 5.00% 5.00% 5.00%
Spread (Fixed) 1.50% 1.50% 1.50%
Total interest payable 6.50% 6.50% 6.50%
Interest CFs on Loan
Libor (floating) (500.000) (500.000) (500.000)

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…
10
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% ?
11
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.
12
Example: Typical presentation by the WSJ. Only regular quartely
matutities are shown. All contracts are for $1 million. Points of 100%.


If interest rate fall by Marche 2003?
14
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

fixed
Floating rate debt Rates to go up Pay fixed/Receive
floating
Rates to go down Do nothing
17
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
18
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%
Spread (fixed) Fixed -1.5% -1.5% -1.5%
Total interest payable -6.50% -6.50% -6.50%
SWAP INTEREST RATE
Pay fixed Fixed -5.75% -5.75% -5.75%
Receive floating Libor Could go up or down +5.00% +5.00% +5.00%
COMBINED LOAN AND SWAP POSITION
LIBOR ON LOAN Paying -5.00% -5.00% -5.00%

three year period.

It wishes to match the currency of denomination of the cash
flows through a currency swap.
21
Pay Swiss Francs and Receive US Dollars
SWAP component Year 0 Year 1 Year 2 Year 3
Will receive fixed US$ at this
rate
5,56% 5,56% 5,56%
on a notional principal of 10.000.000USD
Cash Flow received 556.000USD 556.000USD 10.556.000USD
Exchange rate CHF1,50/USD
Will pay fixed CHF at rate: 2,01% 2,01% 2,01%
On a notional principal of 15.000.000CHF
Cash Flow Carlton will pay 301.500CHF 301.500CHF 15.301.500CHF
22
Observation

At the time of the Swap’s inception

Gain or loss throughout the Swap’s life

Nonamortizing Swap vs Unwinding Swap.