1. Chapter 14
Interest Rate and
Currency Swaps

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Interest Rate Risk
• All firms – domestic or multinational, small or large,
leveraged, or unleveraged – are sensitive to interest
rate movements in one way or another.
• The single largest interest rate risk of the nonfinancial
firm (our focus in this discussion) is debt service; the
multicurrency dimension of interest rate risk for the
MNE is of serious concern.
• The second most prevalent source of interest rate risk
for the MNE lies in its holdings of interest-sensitive
securities.

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Management of Interest Rate Risk
• Before they can manage interest rate risk, treasurers and
financial managers of all types must resolve a basic
management dilemma: the balance between risk and
return.
• Treasury has traditionally been considered a service center
(cost center) and is therefore not expected to take positions
that incur risk in the expectation of profit (treasury
management practices are rarely evaluated as profit
centers).
• Treasury management practices are therefore
predominantly conservative, but opportunities to reduce
costs or actually earn profits are not to be ignored.

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Management of Interest Rate Risk
• Both foreign exchange and interest rate risk management must focus
on managing existing or anticipated cash flow exposures of the firm.
• As in foreign exchange management exposure, the firm cannot
undertake informed management or hedging strategies without
forming expectations – a directional and/or volatility view – of interest
rate movements.
• Fortunately, interest rate movements have historically shown more
stability and less volatility than foreign exchange rate movements.
• Once management has formed expectations about future interest rate
levels and movements, it must choose the appropriate implementation,
a path that includes the selective use of various techniques and
instruments.

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Management of Interest Rate Risk
• Prior to describing the management of the most
common interest rate pricing risks, it is important to
distinguish between credit risk and repricing risk.
• Credit risk, sometimes termed roll-over risk, is the
possibility that a borrower’s credit worthiness, at the
time of renewing a credit, is reclassified by the lender
(resulting in changes to fees, interest rates, credit line
commitments or even denial of credit).
• Repricing risk is the risk of changes in interest rates
charged (earned) at the time a financial contract’s rate
is reset.

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Management of Interest Rate Risk
• As an example, Carlton Corporation has taken out
a three-year, floating-rate loan in the amount of
US$10 million (annual interest payments).
• Some alternatives available to management as a
means to manage interest rate risk are as follows:
– Refinancing
– Forward rate agreements
– Interest rate futures
– Interest rate swaps

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Management of Interest Rate Risk
• A forward rate agreement (FRA) is an interbank-traded
contract to buy or sell interest rate payments on a notional
principal.
• These contracts are settled in cash.
• The buyer of an FRA obtains the right to lock in an interest
rate for a desired term that begins at a future date.
• The contract specifies that the seller of the FRA will pay
the buyer the increased interest expense on a nominal sum
(the notional principal) of money if interest rates rise
above the agreed rate, but the buyer will pay the seller the
differential interest expense if interest rates fall below the
agreed rate.

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Management of Interest Rate Risk
• Unlike foreign currency futures, interest rate futures
are relatively widely used by financial managers and
treasurers of nonfinancial companies.
• Their popularity stems from the relatively high
liquidity of the interest rate futures markets, their
simplicity in use, and the rather standardized interest-
rate exposures most firms possess.
• The two most widely used futures contracts are the
Eurodollar futures traded on the Chicago Mercantile
Exchange (CME) and the US Treasury Bond Futures
of the Chicago Board of Trade (CBOT).

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Management of Interest Rate Risk
• Interest rate futures strategies for common exposures:
– Paying interest on a future date (sell a futures contract/short
position)
• If rates go up, the futures price falls and the short earns a profit
(offsets loss on interest expense)
• If rates go down, the futures price rises and the short earns a loss
– Earning interest on a future date (buy a futures contract/long
position)
• If rates go up, the futures price falls and the short earns a loss
• If rates go down, the futures price rises and the long earns a
profit

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Management of Interest Rate Risk
• Swaps are contractual agreements to exchange or swap a series
of cash flows.
• These cash flows are most commonly the interest payments
associated with debt service, such as the floating-rate loan
described earlier.
– If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it is
termed an interest rate swap
– If the agreement is to swap currencies of debt service obligation, it
is termed a currency swap
– A single swap may combine elements of both interest rate and
currency swaps

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Management of Interest Rate Risk
• The swap itself is not a source of capital, but
rather an alteration of the cash flows associated
with payment.
• What is often termed the plain vanilla swap is
an agreement between two parties to exchange
fixed-rate for floating-rate financial
obligations.
• This type of swap forms the largest single
financial derivative market in the world.

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Management of Interest Rate Risk
• Since all swap rates are derived from the yield curve in each
major currency, the fixed- to floating-rate interest rate swap
existing in each currency allow firms to swap across currencies.
• The usual motivation for a currency swap is to replace cash flows
scheduled in an undesired currency with flows in a desired
currency.
• The desired currency is probably the currency in which the firm’s
future operating revenues (inflows) will be generated.
• Firms often raise capital in currencies in which they do not
possess significant revenues or other natural cash flows (a
significant reason for this being cost).

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Carlton Corporation:
Swapping to Fixed Rates
• Carlton Corporation’s existing floating-rate loan is now the
source of some concern.
• Recent events have led management to believe that interest
rates, specifically LIBOR, may be rising in the three years
ahead.
• As the loan is relatively new, refinancing is considered too
expensive but management believes that a pay fixed/receive
floating interest rate swap may be the better alternative for
fixing future interest rates now.
• This swap agreement does not replace the existing loan
agreement; it supplements it.
• Note that the swap agreement applies only to the interest
payments on the loan and not the principal payments.

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Carlton Corporation: Swapping Floating
Dollars into Fixed-Rate Swiss Francs
• After raising US$10 million in floating-rate
debt, and subsequently swapping into fixed-
rate payments, management decides it would
prefer to make its payments in Swiss francs.
• Since the company has a natural inflow of
Swiss francs (sales contract) it may decide to
match the currency of its debt denomination to
its cash flows with a currency swap.
• Carlton now enters into a three-year pay Swiss
francs and receive US dollars currency swap.

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Carlton Corporation: Swapping Floating
Dollars into Fixed-Rate Swiss Francs
• The three-year currency swap entered into by
Carlton is different from the plain vanilla
interest rate swap described in two important
ways:
– The spot exchange rate in effect on the date of the
agreement establishes what the notional principal is
in the target currency.
– The notional principal itself is part of the swap
agreement (because in a currency swap the notional
principals are denoted in two currencies, the
exchange rate between which is likely to change
over the life of the swap).

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Carlton Corporation:
Unwinding Swaps
• As with all original loan agreements, it may
happen that at some future date the partners to
a swap may wish to terminate the agreement
before it matures.
• Unwinding a currency swap requires the
discounting of the remaining cash flows under
the swap agreement at current interest rates,
then converting the target currency (Swiss
francs) back to the home currency (US dollars)
of the firm.

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Counterparty Risk
• Counterparty risk is the potential exposure any individual firm
bears that the second party to any financial contract will be unable
to fulfill its obligations under the contract’s specifications.
• Counterparty risk has long been one of the major factors that
favor the use of exchange-traded rather than over-the-counter
derivatives.
• Most exchanges, like the Philadelphia Stock Exchange or Chicago
Mercantile Exchange are themselves counterparty to all
transactions.
• The real exposure of an interest or currency swap is not the total
notional principal, but the mark-to-market values of differentials
in interest of currency interest payments.

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Illustrative Case: A Three-Way
Back-to-Back Cross-Currency Swap
• Individual firms often find special demands for their
debt in select markets, allowing them to raise capital at
several points lower there than in other markets.
• Thus, a growing number of firms are confronted with
debt service in currencies that are not normal for their
operations.
• The result has been a use of debt issuances coupled
with swap agreements from inception.
• The following exhibit depicts a three-way borrowing
plus swap structure between a Canadian province, a
Finnish export agency, and a multilateral development
bank.

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Exhibit 14.10 A Three-way Back-to-Back
Cross-Currency Swap
Finish Export Credit
(Finland)
Province of Ontario
(Canada)
Inter-American
Development Bank
Borrows $390 million
at US Treasury + 48 basis points
$260
million
$130
million
Borrows C$300 million
at Canadian Treasury + 47 basis points
Borrows C$150 million
at Canadian Treasury + 44 basis points
C$300
million
C$150
million

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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• An interest rate cap is an option to fix a ceiling
or maximum short-term interest-rate payment.
• The contract is written such that the buyer of
the cap will receive a cash payment equal to
the difference between the actual market
interest rate and the cap strike rate on the
notional principal, if the market rate rises
above the strike rate.
• Like any option, the buyer of the cap pays a
premium to the seller of the cap up front for
this right.

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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• An interest rate floor gives the buyer the right
to receive the compensating payment (cash
settlement) when the reference interest rate falls
below the strike rate of the floor.

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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• No theoretical limit exists to the specification of caps
and floors.
• Most currency cap markets are liquid for up to ten
years in the over-the-counter market, though the
majority of trading falls between one and five years.
• An added distinction that is important to understanding
cap maturity has to do with the number of interest rate
resets involved.
• A common interest rate cap would be a two-year cap
on three-month LIBOR.

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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• The value of a capped interest payment is
composed of three different elements (3-year,
3-month LIBOR reference rate cap):
– The actual three-month payment
– The amount of the cap payment to the cap
buyer if the reference rate rises above the
cap rate
– The annualized cost of the cap

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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• Interest rate floors are basically call options on an
interest rate, and equivalently, interest rate floors
are put options on an interest rate.
• A floor guarantees the buyer of the floor option a
minimum interest rate to be received (rate of return
on notional principal invested) for a specified
reinvestment period or series of periods.
• The pricing and valuation of a floor is the same as
that of an interest rate cap.

25. Exhibit 14A.2 Profile of an Interest Rate Cap
Interest Rate
Payment (%)
Actual 3-month LIBOR on reset date (%)
5.00
5.50
6.00
6.50
7.00
5.50 6.00 6.50 7.50 8.007.00
7.50
Uncovered interest
rate payment
Capped interest
rate payment
The effective “cap”
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26. Exhibit 14A.3 Profile of an Interest Rate Floor
German firm’s effective
investment rate (%)
6-month DM LIBOR on reset date (%)
4.00
4.50
5.00
5.50
6.00
4.50 5.00 5.50 6.50 7.006.00
6.50
Uncovered interest
earnings
Interest earnings
with floor
The effective “floor”
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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• An interest rate collar is the simultaneous
purchase (sale) of a cap and a sale (purchase)
of a floor.
• The firm constructing the collar earns a
premium from the sale of one side to cover in
part of in full the premium expense of
purchasing the other side of the collar.
• If the two premiums are equal, the position is
often referred to as a zero-premium collar.

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Exhibit 14A.4 Profile of an Interest Rate Collar
Firm’s interest
rate payment (%)
Actual market interest rate (%)
0.00
2.00
4.00
6.00
8.00
0.5 1.5 3.5 5.5 6.54.5
Uncovered interest
rate payment
Interest rate cap
2.5
1.00
3.00
5.00
7.00
9.00
Interest rate floor
Floor strike
rate
Cap strike
rate

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Chapter 14 Appendix: Advanced
Topics in Interest Rate Management
• The purchase of a swap option, a swaption,
gives the firm the right but not the obligation to
enter into a swap on a pre-determined notional
principal at some defined future date at a
specified strike rate.
• A firm’s treasurer would typically purchase a
payer’s swaption, giving the treasurer the right
to enter a swap in which they pay the fixed rate
and receive the floating rate.