Multinational Business Finance 12th Edition Slides Chapter 09

Chapter 9

Interest Rate and Currency Swaps

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.

9-2

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.

9-2

Exhibit 9.1 International Interest Rate Calculations

9-3

Management of Interest Rate Risk • The second most prevalent source of interest rate risk for the MNE lies in its holdings of  interest-sensitive securities. • Unlike debt, which is recorded on the righthand side of the firm’s balance sheet, the marketable securities portfolio of the firm appears on the left-hand side. • Marketable securities represent potential earnings for the firm.

9-4

Exhibit 9.2 U.S. Dollar-Denominated Interest Rates (February 2004)

9-5

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.

9-6

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.

9-7

Exhibit 9.3 Treasury Policy Statements

9-8

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. 9-9

Exhibit 9.4 Trident Corporation’s Costs and Cash Flows in Servicing a Floating Rate Loan

9-10

Management of Interest Rate Risk • As an example, Trident 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

9-11

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.

9-12

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).

9-13

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

9-14

Exhibit 9.5 Eurodollar Futures Prices

9-15

Exhibit 9.6 Interest Rate Futures Strategies for Common Exposures

9-16

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

9-17

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 fixedrate for floating-rate financial obligations. • This type of swap forms the largest single financial derivative market in the world.

9-18

Management of Interest Rate Risk • The two parties may have various motivations for entering into the agreement. • A very common situation is as follows: – A corporate borrower of good credit standing has existing floating-rate debt service payments. – The borrower, may conclude that interest rates are about to rise. – In order to protect the firm against rising debt-service payments, the company’s treasury may enter into a swap agreement to pay fixed/receive floating. – This means the firm will now make fixed interest rate payments and receive from the swap counterparty floating interest rate payments.

9-19

Management of Interest Rate Risk • Similarly, a firm with fixed-rate debt that expects interest rates to fall can change fixed-rate debt to floating-rate debt. • In this case, the firm would enter into a  pay floating/receive fixed interest rate swap. • Interest rate swaps are also known as coupon swaps.

9-20

Exhibit 9.7 Interest Rate Swap Strategies

9-21

Exhibit 9.8 Comparative Advantage and Structuring a Swap Agreement

9-22

Management of Interest Rate Risk • Implementation of the Interest Rate Swap: – Unilever borrows at the fixed rate of 7% per annum, and then enters into a receive fixed / pay floating interest rate swap with Citibank. – Unilever agrees in turn to pay Citibank a floating rate of  interest; one-year LIBOR. – Xerox borrows at the floating rate of LIBOR plus 3/4%, and then swaps the payments with Citibank. Citibank agrees to service the floating-rate debt payments on behalf of Xerox. – Xerox agrees in turn to pay Citibank a fixed rate of interest, 7.875%, enabling Xerox to make fixed-rate debt service payments – which it prefers – but at a lower cost of funds than it could have acquired on its own.

9-23

Carlton Corporation: Swapping to Fixed Rates • Trident 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. 9-24

Exhibit 9.9 Trident Corporation’s Interest Rate Swap to Pay Fixed/Receive Floating

9-25

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).

9-26

Exhibit 9.10 Interest Rate and Currency Swap Quotes

9-27

Trident 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. • Trident now enters into a three-year pay Swiss francs and receive US dollars currency swap. 9-28

Trident Corporation: Swapping Floating Dollars into Fixed-Rate Swiss Francs • The three-year currency swap entered into by Trident 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). 9-29

Exhibit 9.11 Trident Corporation’s Currency Swap: Pay Swiss Francs and Receive U.S. Dollars

9-30

Trident 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.

9-31

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.

9-32

Mini-Case Questions: McDonald’s Corporation’s British Pound Exposure • How does the cross-currency swap effectively hedge the three primary exposures McDonald’s has relative to its British subsidiary? • How does the cross-currency swap hedge the long-term equity exposure in the foreign subsidiary? • Should Anka – and McDonald’s – worry about OCI? 9-33