Currency swap: Contract that commits two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.
A currency swap has three stages:
An initial exchange of principal: the two counterparties exchange principal amounts at an agreed exchange rate. This can be a notional exchange since its purpose is to establish the principal amounts as a reference point for the calculation of interest payments and the re-exchange of the principal amounts.
Exchange of interest payments on agreed dates based on outstanding principal amounts and agreed fixed interest rates.
- Re-exchange of the principal amounts at a predetermined exchange rate so the parties end up with their original currencies.
- Again this may be done to hedge risk, to speculate on changes in exchange rates, or to attempt to lower the cost of borrowing by borrowing in the currency in which the most favourable interest rates are available and then swapping into the currency that the firm needs to carry out its business. Whether this will be cheaper will depend among other things on the bid—offer spread.
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A eurobond is a debt security handled internationally by syndicates, groups of bankers and/or brokers who underwrite and distribute new issues of securities or large blocks of outstanding issues. It is typically in bearer (non-registered form) and is issued outside the country of the currency in which it is denominated.
Borrowers and lenders are spread around the world, while the intermediaries are spread across Europe, with the majority of business being done from London. The market was founded in the early 1960s and has provided a competitive source of funding for borrowers who can tap discreet but important sources of finance. Japanese banks, pension funds and insurance companies have become important lenders in recent years and there are still plenty of wealthy individuals who prefer the anonymity offered by bearer securities. The eurobond market is the world’s second largest securities market after the US bond market in terms of trading volume and the third largest after the US and Japanese bond markets in terms of debt outstanding. Read the rest of this entry »
A major defence industry supplier, Death Mines plc, wishes to borrow £1 million for twelve years at a fixed interest rate to finance a new investment project. It could do so by issuing a straight eurobond but, as it is not well known in the market and does not have a high credit risk rating, would have to pay a coupon of 8 per cent which it regards as too high. The firm’s own bank is willing to lend Death Mines the required amount via a one-year floating rate note at a rate of 2 per cent over LIBOR, currently at 3.6 per cent.
Clearly, the floating rate loan is much cheaper at the moment, but LIBOR could easily rise over the period of the loan to such a level that Death Mines would finish up losing on the project. Thus, it enters into a contract with a swap bank, Border International, to pay to it 5 per cent on the principal, receiving in exchange LIBOR.
The position of Death Mines now is:
Pays to its own bank LIBOR + 2 per cent
Pays to Border 5 per cent
Receives from Border LIBOR
Net position — fixed rate loan at 7 per cent Read the rest of this entry »
By far, the most popular type of credit derivative is the credit default swap. It is categorized as one of two credit default products. Not only is this form of credit derivative the most commonly used stand-alone product, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations, which will be discuss later. A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Because of the popularity of credit default swaps, the other type of credit default product —the credit default option—is rarely used. Hence, we will not discuss that product here.
Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default swaps operate much like a standby letter of credit or insurance policy. In contrast, a total return swap allows an investor to increase exposure to a reference obligation. Read the rest of this entry »
Earlier we provided two interpretations of a swap: (1) a package of futures/forward contracts, and (2) a package of cash market instruments. The swap spread is determined by the same factors that influence the spread over Treasuries on financial instruments (futures/forward contracts or cash) that produce a similar return or funding profile. As we explain subsequently, the key determinant of the swap spread for swaps with maturities of five years or less is the cost of hedging in the Eurodollar CD futures market. For longer maturity swaps, the key determinant of the swap spread is the credit spreads in the corporate bond market. Read the rest of this entry »
The interest-rate swap was developed in late 1981. By 1987, the market had grown to more than $500 billion (in terms of notional principal amount). What is behind this rapid growth? As our asset/liability application earlier demonstrated, an interest-rate swap is a quick way for institutional investors to change the nature of assets and liabilities or to exploit any perceived capital market imperfection. The same applies to borrowers such as corporations, sovereigns, and supranationals.
In fact, the initial motivation for the interest-rate-swap market was borrower exploitation of what were perceived to be “credit arbitrage” opportunities because of differences between the quality spread between lower- and higher-rated credits in the U.S. and Eurodollar bond fixed-rate market and the same spread in these two floating- rate markets. Basically, the argument for swaps was based on a well-known economic principle of comparative advantage in international economics. Read the rest of this entry »
