Module 2.

Interest Rate and Currency Swaps

Chapter 14

Massey University | massey.ac.nz | 0800 MASSEY

Outline
⚫ Interest rate swap
⚫ Currency swap
⚫ Quality spread differential (QSD)
⚫ Cash flows of swaps
⚫ Valuation of swaps
The Definition of Swap
Swap is an agreement between two counterparties to
exchange cash flows at periodic intervals.

⚫ Single currency interest rate swap (interest rate swap)

Fixed-for-floating: exchange of interest payments of a fixed-
rate debt obligation for a floating-rate interest payments in the
same currency denomination.

⚫ Cross-currency interest rate swaps (currency swap)

Exchange the principal and interest payments in one currency
for principal and interest payments in another currency.
Swap Bank
A swap bank is a financial institution that facilitates
swaps between counterparties.
⚫ Makes a market and provides quotations.
⚫ Can tailor the terms of swaps to customers’ needs.

As a broker: matches counterparties but does not

assume any of the risks of the swap.

As a dealer: stands ready to accept either side of a

currency swap, and then match it with a counterparty.
Interest Rate Swap Quotations
The convention is to quote against USD LIBOR
Euro-€ £ Sterling U.S. $
Bid Ask Bid Ask Bid Ask
1 year 2.34 2.37 5.21 5.22 3.54 3.57
2 year 2.62 2.65 5.14 5.18 3.90 3.94
3 year 2.86 2.89 5.08–5.13
5.13 means
5.17 the swap
4.11 bank will
4.13
4 year 3.06 3.09 pay fixed-rate
5.12 5.17£ Sterling
4.25 at 5.08%
4.28
5 year 3.23 3.26 against
5.11 receiving
5.16 USD LIBOR,4.39
4.37 or it
6 year 3.38 3.41 will
5.11receive5.16
fixed-rate4.46
£ Sterling4.50at
7 year 3.52 3.55 5.13%
5.10 against
5.15paying4.55
USD LIBOR.4.58
8 year 3.63 3.66 5.10 5.15 4.62 4.66
9 year 3.74 3.77 5.09 5.14 4.70 4.72
10 year 3.82 3.85 5.08 5.13 4.75 4.79
Illustration of Swap Quotations
A “plain vanilla” fixed-for-floating swap quotes of
5.08–5.13 mean:

Firm £5.13% Swap £5.08% Firm

X $LIBOR Bank $LIBOR Y

⚫ Most swaps are quoted against “flat” dollar LIBOR,

⚫ “Off-market” swaps are available where one party
pays LIBOR plus or minus some number.
Interest Rate Swap: Example
Firm Fixed Floating Both firms want to
A 5% LIBOR borrow $40 million
B 5.50% LIBOR + 0.20% for two years.

• A wants to finance an interest-rate-sensitive asset

and therefore wants to borrow at a floating rate.
• B wants to finance an interest-rate-insensitive asset
and therefore wants to borrow at a fixed rate.
▪ The swap bank quotes a 2-year swap as 5.1- 5.2
against dollar LIBOR.
The Quality Spread Differential (QSD)
Fixed Floating
A 5% LIBOR
B 5.50% LIBOR + .20%
Spread (B-A) 0.50% 0.20%
QSD 0.50% - 0.20% = 0.30%

QSD = |∆Fixed - ∆Floating|

➢ The QSD represents the potential gain from a swap
that can be shared among the counterparties and the
swap bank.
Transactions Involving Firm A
Firm A can borrow from its commercial bank at 5.0%
fixed, then takes up the swap bank’s offer of 5.1-5.2
to receive 5.1% fixed in exchange for paying a
floating rate of LIBOR.
Bank
X
Firm 5.10% Swap
A Bank
LIBOR

Firm A’s all-in-cost:

-5.0% + (5.10% - LIBOR) = - (LIBOR – 0.10%)
Transactions Involving Firm B
If firm B borrows floating from its commercial bank
at LIBOR+0.20% and takes up the swap bank’s offer
of 5.1-5.2, B can convert its floating rate debt into a
fixed rate debt:

Swap 5.20% Firm

Bank B Bank
LIBOR
Y
Firm B’s all-in cost:
-(LIBOR + 0.20%) + (LIBOR - 5.20%) = - 5.40%
Bank Summary Bank
X Y

Firm 5.10% Swap 5.20% Firm

A LIBOR Bank LIBOR B
without Swap with Swap Benefit
A LIBOR LIBOR - 0.10% 0.10%
B 5.50% 5.40% 0.10%
Swap Bank 0.10%
On a notional principal (NP) of $40 million, A and B
will both save $40,000 each year over two years.
Example (cont.): Cash Flows at T = 0

Firm Swap Firm

A Bank B

In this “plain vanilla” interest-

only interest rate swap, there
Bank is no swap of the Notational Bank
X Principal. Y
Example (cont.): Interest Rates at T = 1

Suppose LIBOR= 3% (NP = $40,000,000)

Firm 5.10% Swap 5.20% Firm

A LIBOR Bank LIBOR B

LIBOR +0.2%
• Swap Bank gets 0.1% of NP
Bank net CF = $40,000 Bank
X Y
Example (cont.): Cash Flows at T = 1
Suppose LIBOR= 3% (NP = $40,000,000)

2.10% 2.20%

Firm $840,000 Swap $880,000 Firm

A Bank B

$1,280,000
$2,000,000

3.2%
• A’s net CF = -$1,160,000
(effective cost = 2.9%)
Bank • B’s net CF = -$2,160,000 Bank
X (effective cost = 5.4%) Y
Example (cont.): Interest Rates at T = 2
Suppose LIBOR= 5% (NP = $40,000,000)

Firm 5.10% 5.20% Firm

Swap
A LIBOR Bank B
LIBOR

LIBOR + 0.2%
Bank Bank
X Y
Example (cont.): Cash Flows at T = 2
NP = $40,000,000 , Suppose LIBOR= 5%

Firm 0.10% 0.20% Firm

Swap
A $40,000 B
Bank $80,000
$40,000,000

$2,000,000

$40,000,000
$2,080,000
5.2%
• A’s net CF: -NP & -$1,960,000
(effective cost = 4.9%).
Bank Bank
• B’s net CF: -NP & -$2,160,000
X Y
(effective cost = 5.4%).
Direct Swap Fixed Floating
A 5% LIBOR
B 5.50% LIBOR + .20%

Suppose Firm A wants to borrow at a floating rate. Firm

B wants to borrow at a fixed rate to finance an interest-
rate-insensitive asset.
QSD = 0.30%. A and B can bypass the swap bank by
entering into a direct swap.
➢A agrees to pay B floating at LIBOR in exchange
for receiving 5.15% from B.
➢Or, A agrees to pay B floating at LIBOR-0.15% in
exchange for receiving 5% fixed from B.
Currency Swap: Example
⚫ A is an US firm. A wants to borrow €40 million for 3
years to finance an euro denominated asset in Italy.
⚫ B is a French Firm. B wants to borrow $60 million
for 3 years to finance a USD denominated asset in
the US.
⚫ Current exchange rate is $1.50 / €.
⚫ External borrowing opportunities are:
$ €
A $7% €6%
B $8% €5%
The Comparative Advantage of Borrowing
$ €
A $7% €6%
B $8% €5%
Spread (B-A) 1% –1%
QSD 1% - (-1%) = 2%

⚫ A has a comparative advantage in borrowing USD.

⚫ B has a comparative advantage in borrowing the euro.
Example (cont.): Swaps with a Swap Bank
A Swap Bank quotes the following fixed rates against
U.S. dollar LIBOR.

USD Euro
Bid Ask Bid Ask
3 year 7.00 7.20 5.00 5.20

$ € ⚫ A can borrow euro at a lower

cost from the swap bank.
A $7% €6% ⚫ B can borrow USD at a lower
B $8% €5% cost from the swap bank.
Deals Involving Firm A
Firm A can borrow $60m at $7% and exchange this
debt with the swap bank for a loan in €
- effectively enters into two fixed for floating swaps.
S =$1.50/€. $60m
LIBOR
Bank $7.0% Firm $7.0% Swap
X $60m A €5.2% Bank

USD Euro LIBOR

Bid Ask Bid Ask
7.00 7.20 5.00 5.20 €40m
Deals Involving Firm B
Firm B can borrow €40m at €5% and exchange this
debt with the swap bank for a loan in $
- Effectively enters into two fixed for floating swaps.
$60m S = $1.50 / €.
LIBOR
Swap $7.2% Firm €40m Bank
Bank €5.0% B €5%
Y
LIBOR
USD Euro
€40m Bid Ask Bid Ask
7.00 7.20 5.00 5.20
Example (cont.): Swap bank’s transactions

$60m $60m

LIBOR LIBOR
Firm $7.0% Swap $7.2% Firm
A €5.2% Bank €5.0% B
LIBOR LIBOR

€40m €40m
Example (cont.): summary

without Swap with Swap Benefit

A (on €40m) €6% €5.2% €0.8%
B (on $60m) $8% $7.2% $0.8%
Swap Bank $0.2% + €0.2%

On a notional size of $60mil (€40mil), 3-year loan:

• A and B each saves 80 bp per year.
• Swap Bank earns 40 bp per year (20bp on $60mil
and 20bp on €40mil).
 Example (cont.): Cash Flows at T = 0
S0 = $1.50 / €

Firm Swap Firm

A Bank B

€40,000,000

$60,000,000 $60,000,000

Bank Bank
X Y
Example (cont.): Cash Flows at T = 1 (million $ or €)
Suppose LIBOR = 3%, S1 = $1.50/€ (NP: $60 / €40)
$1.8 $1.8

Firm $4.2 Swap $4.32 Firm

A €2.08 Bank €2 B
€1.2 =$1.8 €1.2 =$1.8

• A’s all-in-cost = €2.08mil, or 5.2% of €40mil.

Bank Bank
X • B’s all-in-cost = $4.32mil, or 7.2% of $60mil. Y
• Swap bank earns €0.08mil + $0.12mil
( 0.2% from each side).
Example (cont.): Cash Flows at T = 2 (million $ or €)
Suppose LIBOR = 4%, S2 = $1.50/€ (NP: $60 / €40)
$2.4 $2.4

Firm $4.2 Swap $4.32 Firm

A €2.08 Bank €2 B
€1.6 =$2.4 €1.6 =$2.4

• A’s all-in-cost = €2.08 mil.

Bank Bank
X • B’s all-in-cost = $4.32 mil. Y

• Swap bank earns €0.08mil + $0.12mil

Example (cont.): Cash Flows at T = 3 (million $ or €)

Suppose LIBOR = 5%, S3 = $1.50/€ (NP: $60 / €40)

$3 $3

Firm $4.2 Swap $4.32 Firm

A €2.08 Bank €2 B
€2 =$3 €2 =$3

€40
Bank
Bank
Y
X
Example (cont.): Net Interest Payments at T = 3
Million $ or €, LIBOR=5%, S3=$1.50/€, NP=$60 or €40

Firm $4.2 Swap $4.32 Firm

A €2.08 Bank €2 B

• A’s all-in-cost = €2.08mil

(5.2% loan of €40mil).

Bank • B’s all-in-cost = $4.32mil Bank

X (7.2% loan of $60mil). Y

• Swap bank: €0.08mil+$0.12mil

Example: Direct Currency Swap
$ €
A $7% €6%
B $8% €5%

Firm $7% Firm

A €5% B

• A’s effective cost = €5%

Bank Bank
X • B’s effective cost = $7% Y
Triennial Central Bank Survey, OTC foreign exchange turnover in April 2022.
source: https://www.bis.org/statistics/rpfx22_fx.pdf
Reasons for Using Swaps
The growth of the swap market has been astounding -
NPs of interest rate and currency swaps were $326.7
trillion and $24.9 trillion, respectively, in 2018.

Swaps offer market completeness by providing tailored

financing in the form more suitable for the structure of
asset maturity of a borrower.
⚫ Market constraints: technical, informational or political
obstacles to funding in certain currencies.
⚫ Cost advantage: credit rating, brand name recognition.
⚫ Hedging
The Swap Bank’s Risk
⚫ Credit Risk
⚫ Mismatch Risk
⚫ Interest Rate Risk
⚫ Exchange Rate Risk
⚫ Basis Risk: when floating rates of the two
counterparties are not pegged to the same index.
⚫ Sovereign Risk: a country may impose exchange
rate restrictions that will interfere with performance
on the swap.
Other Variations of Swaps
⚫ Interest Rate Swaps
⚫ zero-coupon for floating
⚫ floating for floating

⚫ Currency Swaps
⚫ fixed for fixed
⚫ floating for floating
⚫ amortizing
The Value of a Swap
A swap can be priced in terms of the present values of
the payment streams that are incoming and outgoing:
Value of swap = PV (incoming payment streams)
- PV( outgoing payment streams)

⚫ Plain vanilla fixed for floating swaps get valued

just like a pair of bonds.
⚫ Currency swap gets valued just like two bonds
denominated in different currencies.
Example: Value of a Currency Swap
A currency swap has a remaining life of 18 months. It
involves exchanging interest at 14% on £20 million
for interest at 10% on $30 million once a year on
anniversary. The current exchange rate is $1.65/£.
If the swap were negotiated today, interest rates
exchanged would be $8% and £11%. The term
structure of interest rates is flat in both countries.
All rates were quoted with annual compounding.
What is the value of the swap to the party paying
interests in dollars?
Solution
To find the value of swap to the party paying dollars:
r$ = 8%
r£ = 11%
0 6 month 18 month

14% on £20mil £2.8mil £22.8mil

-10% on $30mil –$3mil –$33mil

£2.8m £22.8 –$3 –$33

$1.65/£ +
(1.11)½ + (1.11)3/2 × (1.08)½ + (1.08)3/2

= $4,265,022
Homework:
Questions: 2, 3, 5, 8.
Problems: 1-3, 5, 8.

Useful reference:
International Financial Management (chapter 21)
by Geert Bekaert, Robert Hodrick and Bekaert, Geert.
Massey Library Call No. 658.1599 Bek