Swaps Flashcards
Interest Rate Swap
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
Currency Swap
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)
Basic Motivation for currency swap
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.
Risks to the swap dealer
Sovereign risk Mismatch risk Basis risk Exchange rate risk Interest rate risk Credit risk
Sovereign risk
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
Mismatch risk
OTC so customised
Hard to find match one agreed with one party
Credit risk
possibility of one party defaulting and failing to meet half of the contract
swap bank has an obligation to the firm still surviving
Basis Risk
Basis is the difference between two indices
If floating rates are pegged to different benchmarked indices, e.g. LIBOR and BMA
Interest rate risk
Interest rates changing unfavourably before the swap has been laid off
Exchange rate risk
Exchange rates changing unfavourably before the swap has been laid off
Quality Spread
Credit ratings of firms
Premium lower quality has to pay one higher quality
Creates quality spread
Absolute advantage in both
Quality Spread Differential
Difference between the two quality spreads
The shared savings of the two parties in the swap
Explanation of the Quality Spread Differential?
Wall and Pringle (1989) Bankruptcy Long term covenants Agency costs Risk to shareholders
Bankruptcy (QSD)
Lower quality more likely to default
short term difference is marginal
Longer term the difference increases
interest rate premium
Long term covenants
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
Agency Costs
Misalignment of owners, shareholders and creditors interests
Creditors recognise incentives for LT debt - underinvestment and risky projects
Demand higher premium for LT debt
Risk to shareholders
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
Motives for Interest rate swaps
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
Exploitation of information Asymmetry
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
Adjusting the debt level of a firm
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
Adjustment of the repricing intervals of debt
Interest rate management rather than cost reduction
Low cost method with making adjustments in the companies exposure
Tax and regulatory arbitrage
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
