Swaps

Question 1

Interest Rate Swap

Answer 1

Traded OTC with agreed notional amount and time to maturity
Two parties swap their interest rate payments only, not principal amount
Denominated in the same currency
QS and QSD
Absolute advantage in both

Question 2

Currency Swap

Answer 2

Traded OTC with agreed notional amount and time to maturity
Principal amount and interest rate payment
Access another currency at a cheaper rate
can be the same interest rate or can be mixed (which makes it cross currency)

Question 3

Basic Motivation for currency swap

Answer 3

1) access finance at a lower cost than they can do alone

2) hedge exchange exposure as they are certain on the amount to pay and the amount received over the swaps lifetime.

Question 4

Risks to the swap dealer

Answer 4

Sovereign risk
Mismatch risk
Basis risk
Exchange rate risk
Interest rate risk
Credit risk

Question 5

Sovereign risk

Answer 5

possibility of one country imposing exchange rate controls/restrictions that would impact the performance of the swap
Provisions are in place to protect swap bank

Question 6

Mismatch risk

Answer 6

OTC so customised

Hard to find match one agreed with one party

Question 7

Credit risk

Answer 7

possibility of one party defaulting and failing to meet half of the contract
swap bank has an obligation to the firm still surviving

Question 8

Basis Risk

Answer 8

Basis is the difference between two indices

If floating rates are pegged to different benchmarked indices, e.g. LIBOR and BMA

Question 9

Interest rate risk

Answer 9

Interest rates changing unfavourably before the swap has been laid off

Question 10

Exchange rate risk

Answer 10

Exchange rates changing unfavourably before the swap has been laid off

Question 11

Quality Spread

Answer 11

Credit ratings of firms
Premium lower quality has to pay one higher quality
Creates quality spread
Absolute advantage in both

Question 12

Quality Spread Differential

Answer 12

Difference between the two quality spreads

The shared savings of the two parties in the swap

Question 13

Explanation of the Quality Spread Differential?

Answer 13

Wall and Pringle (1989)
Bankruptcy
Long term covenants
Agency costs
Risk to shareholders

Question 14

Bankruptcy (QSD)

Answer 14

Lower quality more likely to default
short term difference is marginal
Longer term the difference increases
interest rate premium

Question 15

Long term covenants

Answer 15

Restricted covenants in long term debt not in short term debt
value greater for lower quality
probability of use likely to increase with time
hence QSD

Question 16

Agency Costs

Answer 16

Misalignment of owners, shareholders and creditors interests
Creditors recognise incentives for LT debt - underinvestment and risky projects
Demand higher premium for LT debt

Question 17

Risk to shareholders

Answer 17

Creditors for firms who issue ST debt bear less risk than creditors of firms who issue LT debt
ST debt holders have the option not to renew their debt when the circumstance change
Therefore creditors of firms who issue ST debt bear less risk then shareholders
Thus equity capitalisation is higher for ST than LT debt

Question 18

Motives for Interest rate swaps

Answer 18

Wall and Pringle (1989)
Exploitation of information asymmetry
Adjusting the debt level of a firm
Adjustment of the repricing intervals of debt
Tax and regulatory arbitrage

Question 19

Exploitation of information Asymmetry

Answer 19

Managers have inside information
Believe market is charging firm too much
Once info is released interest rates will fall
Until then, they use swaps to exploit information but protect from interest rate risks

Question 20

Adjusting the debt level of a firm

Answer 20

Circumstances may change which leads to the firm wanting to adjust debt levels
Swaps allow for debt to be undone with little transaction costs associated with the process
Unlike LT callable debt

Question 21

Adjustment of the repricing intervals of debt

Answer 21

Interest rate management rather than cost reduction

Low cost method with making adjustments in the companies exposure

Question 22

Tax and regulatory arbitrage

Answer 22

Cost of issuing debt differs in different countries
Taking advantage of this
SEC securities exchange commission
Offer USA bonds at 80bps higher than Eurobond market