Term Paper (Advanced seminar), 2006
65 Pages, Grade: 1,0
List of Figures
List of Abbreviations
2.2.2. Role of banks
2.2.3. Other Swaps
2.3. Type of traders
3.2. Hedging strategies
4. Interest rate risk management
4.1. Impact of interest rate risks on companies
4.2. OTC instruments of hedging with interest risks
4.2.1. Forward rate agreement
4.2.2. Interest rate cap
4.2.3. Interest rate floor
4.3. Interest rate swaps
4.3.2. Plain Vanilla Interest Rate Swap
4.3.3. Hedging with interest rate swaps
5. Currency risk management
5.1. Impact of exchange rate risks on companies
5.2. Types of exchange rate risks
5.2.1. Translation risk
5.2.2. Transaction risk
5.2.3. Economic risk
5.2.4. Convertibility and transfer risk
5.2.5. Currency contingent risk
5.3. Hedging of exchange rate risks
5.3.1. Internal Instruments
5.3.2. External Instruments
5.4. Currency Swaps
5.4.1. Predecessors of Currency Swaps
5.4.2. Application of Currency Swaps
6. Analysis of the interest rate swaps and currency swaps
6.1. Risks of swaps
6.2. Advantages of a company at swap market
Figure 1: The financial market system
Figure 2: Interest rate swap between Apple and GM
Figure 3: Cash Flows (Millions of $) to Apple in a $100 Million Three-Year Interest Rate Swap, when a fixed rate of 5% is paid and LIBOR is received
Figure 4: Interest rate flows between GM and Apple
Figure 5: Interest rate flows between GM and Apple
Figure 6: GM and Apple use the Swap to Adapt an Asset
Figure 7: Instruments for Hedging Currency Risks
Figure 8: Parallel Credit
Figure 9: Back-to-Back Credit
Figure 10: Step 1: Initial Exchange and placements of bonds
Figure 11: Step 2: Exchanging of interest rate payments
Figure 12: Step 3: Exchanging back of initially exchanged money amount
Figure 13: Interest rates for taking up credits, motivating to do a cross currency swap
Figure 14: First step of a fixed-for-fixed currency swap
Figure 15: Second step of a fixed-for-fixed currency swap
Figure 16: Third Step of a fixed-for-fixed currency swap.
illustration not visible in this excerpt
Risk management within companies is getting more and more important. The reasons for this development are varied. The most important factor is doubtless the internationalisation of companies. Acting on international markets offers on the one hand numerous chances for an enterprise but on the other hand it also holds an additional risk potential concerning losses. This negative aspect is mainly caused by a lack of information regarding political risk and exchange rate risk.
Risk management is also necessary referring to change in interest rates. It is possible to limit, control and organize the interest rate risk as well as other risks of the company. As the financial outcome of a company gains importance risk management concerning interest rates and exchange rates is thus essential.
To face these risks and other problems that derive of variations in stock markets, interest markets or exchange markets derivative instruments play a significant role. In April 2003 the International Swaps and Derivatives Association (ISDA) published a survey of derivatives usage by the world’s 500 largest companies. According to this study 85% of the companies use derivatives to help manage interest rate risk and 78% of them use derivatives to help manage currency risk. Only 8% of the 500 largest companies do not use derivatives.
There are many different kinds of financial instruments which are very complex in their function.
This paper has its focus on interest rate and currency swaps. By using these instruments it is possible to hedge interest rate risks or currency risks.
The first chapter gives an overview about existing derivatives and about the structure and function of swaps. Moreover the different kinds of traders with emphasis on hedging will be described.
Afterwards the impact of interest risks on companies as well as OTC instruments that are used for hedging are explained. Subsequently the definition of an interest rate swap follows plus the application of this instrument with regard to hedging.
In chapter five the currency risk management and types of exchange rate risks are illustrated. After that it will be explained how to hedge these exchange rate risks. The paper then gives a description of currency swaps and their application. Reasons for swaps in general as well as possible risks will also be pointed out.
In the last part of the paper advantages and disadvantages of swaps concerning hedging will be summarized and a final statement of how swaps are applicable and useful in daily business for companies to hedge interest rate and exchange rate risks will be given.
First of all a definition of the term “derivative” is necessary.
The expression has its origin in the Latin language (“derivare” which means derive). It is a financial contract, whose value derives from a financial instrument or material asset. The object which forms the basis is called the “underlying” of the derivative. These “underlyings” can either be commodities, like i.e. oil and metal or financial objects, like i.e. bonds, interests rates and foreign exchange.
The moment of the conclusion of the contract and the moment of the contract fulfillment of derivative financial instruments are not identical. That is why one can describe a derivative as deal on the forward market. In contrast there are deals on the spot market. Further one can distinguish conditional and absolute forward deals. In terms of absolute forward deals both parties of the contract have to fulfill the deal at a determined date, i.e. forward contracts or swaps. Latter will be explained in detail in course of this paper. Conditional forward contracts have an optional character which means one party has an option to carry out a financial transaction and the counterpart has the obligation to accept the decision. These kinds of deals are i.e. options, futures or swaptions.
Derivatives are either standardized products and traded at the stock exchange or individual negotiated between the intermediary and its customer (called: Over the counter, OTC).
You can see the detailed subdivision of financial derivatives in figure 1.
illustration not visible in this excerpt
Figure 1: The financial market system
A swap is an agreement between two parties which are called counterparties to exchange cash flows in the same or different currency over a certain period of time in future.
Counterparties can be for example insurance companies, multinational companies, investors or banks.
Motivations for Swaps
There are different motivations for swaps. Companies can use swaps to protect themselves against future changes in exchange rates and interest rates or to manage interest rate and foreign currency risk that occur from usual commercial operations. This simply means that they use the opportunity minimize those risks. This is called “Hedging” and will be explained later on (3. Hedging). Other participants prefer speculation (see “types of traders”). Some also use swaps in order to cut financing costs. By using Swaps companies are also able to operate on a larger scale. This is possible by hedging financial price risks. Companies that do not hedge can not operate on the same scale as the one doing hedging. Although hedging is costly, the costs are still a small price to pay if you look at the increased scale at which the company then is able to operate. The company also profits from economies of scale. Swaps furthermore are helpful for companies to access new markets which normally would be difficult to enter as the cost of entering are too high and thus not profitably.
The financial swap market has grown at a rapid pace in the last years. In the 1970’s traders first used currency swaps as possibility to evade British controls on movement of foreign currency. Swaps are used by Multinational companies (MNCs), commercial banks or world organizations. They use it as a further risk management tool along with currency forwards, options and futures. In 1981 the first interest rate swaps occurred in an agreement between the World Bank and IBM. By 1987 Interest swaps with an underlying value of $682.9 billion were outstanding and another $182.8 billion of currency swaps. By 2001, the underlying value of interest swaps was $57 trillion and $4.3 trillion concerning currency swaps. According to the Bank for International Settlements only 5 years later by June 2006, $207.3 trillion were traded via interest rate swaps and $9.6 trillion via currency swaps.
When the swap was introduced the first time each bank that entered the swap markets had its own documentation included language, specification of terms, pricing conventions and other swap provisions. As this lack of standardization led to a restriction of banks to assign swaps the International Swap Dealers Association (ISDA) was founded in June 1985. This association launched a code listing standard terms and conditions for interest rate swaps. The British Banker’s Association also established its own guidelines only a little later. After revising these codes later they led to the introduction of standard form agreements.
As a result of the standardization of documentation transacting could speed up the writing of swaps was facilitated and the development of a secondary market in swaps could urged on.
The two basic kinds of swaps are interest rate and currency swaps. Also very popular is a mixture of these two swaps known as cross currency swap. Furthermore there are many other types and variations of swaps and there is no limit for the quantity of swaps that can be created and negotiated for individual use.
Depending on the interest rate agreement, three different types of swaps are differentiated:
- fixed-for-fixed swap
- fixed-for-floating swap
- floating-for-floating swap
In a fixed-for-fixed swap the swap partners exchange during the maturity fixed interest rate payments.
The fixed-for-floating swap consists of one swap party delivering fixed interest rates and the other party delivering payments based on floating interest rates. Another type of swaps is the floating-for-floating swap, where both partners agree on floating interest rates.
There are three possibilities to terminate a swap.
The first one is called reversal or offset which is the most common way to close the position. It simply means that the bank enters into another interest swap with the same terms and conditions but structured that way that the cash flows on the new swap offset the cash flows on the old one.
If a swap contract is terminated before its usual end it is called a “close out”. Both parties agree to eliminate the swap and to pay the difference at the actual date at the actual market price for the remaining period.
It is also possible to pass the swap to a third partner that is called sale or assignment. This new partner has to agree to take over all the obligations and furthermore has to accept its receipts on the swap. Moreover the new swap partner has to accept its swap counterpart as well as the origin partner.
In many interest rate swap agreements the London Interbank Offered Rate called LIBOR is the floating rate. It is the most known reference rate on the money market and the rate of interest offered by banks on deposits from other banks. This index is the average interest rate of the Offered-Rates of several international commercial banks in London to which other commercial banks offer money on term deposit. The LIBOR rates change continuously as economic conditions change as well. For every important currency a separate LIBOR exists. The one-Month LIBOR is the interest rate to which one month deposits are offered, the three-Month LIBOR is the interest rate to which three month deposits are offered and so on.
Sometimes the floating rate in interest rate swap agreements can also be the European Interbank Offered Rate which replaced the former Frankfurt Interbank Offered Rate (FIBOR). This is the interest rate for money on term deposit in Euro which is dealt between banks. The EURIBOR is published in the daily newspaper. The published rate is both the basis for negation of short term credits and good information to facilitate negotiations of fixed-term deposit interest rates with the bank.
A confirmation describes a legally binding agreement a swap is based on and the counterparts have to sign. The ISDA draw them up. Within this confirmation one can find every detail of the swap agreement i.e. conclusion date, end day, payer and receiver, fixed interest rate, floating rate and the dates for the exchange of the payments.
A bank plays different roles in the swap business. First it can act as arranger which means that the bank brings together two potential swap partners. That way the bank provides know-how but has no contract with both of the partners and hence bears no risk.
Second, the bank acts as intermediary. Usually the two non-financial partners do not know each other and do not get in touch directly to arrange a swap. This is the most common way. As intermediary the bank enters into two offsetting swap transactions with two companies. In this case the bank has two separate contracts with each company. If one company defaults the financial institution is nevertheless obliged to honour its agreement with the other company. So the bank takes the risk.
The last role a bank can play is as an active partner. This means that the bank itself buys or sells a swap and thus takes as well a risk of credit standing and market price.
The focus of this paper lies on hedging with interest rate swaps, currency swaps or cross currency swaps. But there are many other types of swaps which will be listed briefly.
In terms of interest swaps i.e. one can use different floating rates besides the most used six months LIBOR. Possible is among others also the three month LIBOR or the six month EURIBOR. Furthermore it is possible to adopt the capital of a swap transaction to an amortization plan (amortizing swap). The other way around the capital can be scheduled to increase in an accreting swap or step-up swap. In case of deferred or forward swaps the exchange of payments starts not before a coming agreed date. Moreover there are extendible or cancellable swaps. Other forms of swaps are constant-maturity swaps, yield curve swaps, differential swap or diff swap and corridor swaps. In terms of commodity swaps the parties do payments which are based on the price of a specified amount of a commodity whereas in equity swaps the payments base on a notional capital specified as stock portfolio. A swaption is a special construction representing an option on a swap whose form can be either American or European.
There are three motivations of enterprises to use derivative financial instruments.
The first kind of motivation is the speculation. Speculators are not afraid of being exposed to adverse movements in the price of an asset. They observe the market and dependent on their expectation they invest in a chosen derivative with the aim to achieve a satisfying profit. They either bet on rising prices or they bet on falling prices. Both high profits and high losses may result from speculations.
Say for example, today on January 1st, that a trader thinks that the pound sterling will strengthen compared to the US dollar over the following two months. He wants to invest ₤ 250,000 and he can take a buying position in a forward contract on ₤ 250,000. The actual exchange rate is $1.6222. This means that he has the chance to buy an asset to this fixed rate on March 1st. If the exchange rate is i.e. $1.7000 he is able to realize a profit of $19,450.
19.450 = (1.7000 – 1.6222) x 250,000
If the exchange rate is lower than $1.6222 he suffers a loss.
Arbitrageurs are another type of traders. Arbitrage means that you take advantage of short-term price differences between two or more markets to achieve a profit without any risk. They are both speculators and hedgers. As markets usually have the tendency to even out any imbalance and only little price differences occur the possible profit is low in relation to the invested sum. Therefore low transaction costs and high transaction volume constitute the requirements to be successful in Arbitrage. Consider a stock traded on both the London Stock Exchange and the New York Stock Exchange. Say the price is $172 in NY and 100 pounds in London. The exchange rate is $1.7500 per pound. Now an arbitrageur could at the same time buy 100 shares in NY and sell them in London. So he could obtain a profit of $300 (transaction costs not included).
₤ 300 = 100 x [($1.75x100) - $172]
Hedgers are the third important group of traders and as the paper has its focus on hedging with swaps this type will be illustrated in detail in chapter 3.
Like arbitrageurs a hedger wants to avoid risks concerning an investment as good as possible. Hedging means the reduction of risks of several risk categories.
The term risk is not homogenously defined in business management. A risk situation can be characterized that way that probabilities for positive or negative deviations of an expected value can be indicated contrary to the uncertainty. A risk is also the danger of the failure of a performance. In terms of economical risks not only risks are interesting which lead to payments but also those risks where a loss in the form of missed profits occur (also called opportunity costs).
The main goal of hedgers is the neutralization of exchange rate and interest rate fluctuations which influence a portfolio. In return they accept a lower yield. They can secure risks by using swaps, forward contracts or other derivatives. Taking swaps they can either use currency swaps to ensure the actual exchange rate of a currency or they can use interest rate swaps in order to ensure fix interest rates instead of unstable variable interest rates. Hedgers usually stand in relation to speculators, who take the exchange rate risk away from them for adequate pay. Typical hedgers are banks, insurance companies or investors who are exposed to unexpected price fluctuation which they want to reduce. Often industrial companies, importers or exporters, are among this type of traders as they act internationally and are usually obliged to fulfill a payment or
to receive a payment in a foreign currency. Single private players on the market are rare among hedgers. Swaps are best suited to hedge price risks of a longer term which means the duration can range from one to ten or more years.
If an exposure or a transaction is not hedged you call this an open position whereas a hedged transaction is called a closed position. Therefore one can say that by concluding a swap deal which is exposed to a contrary risk it is possible to hedge the basic deal. The risk of the basic deal thus represents an opportunity for the hedge and the other way round.
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