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CHAPTER 14 INTEREST RATE AND CURRENCY SWAPS
1. Describe the difference between a swap broker and a swap dealer.
Answer: A swap broker arranges a swap between two counterparties for a fee without taking a
2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?
Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality
3. Discuss the basic motivations for a counterparty to enter into a currency swap.
4. How does the theory of comparative advantage relate to the currency swap market?
Answer: Name recognition is extremely important in the international bond market. Without it,
even a creditworthy corporation will find itself paying a higher interest rate for foreign
5. Discuss the risks confronting an interest rate and currency swap dealer.
Answer: An interest rate and currency swap dealer confronts many different types of risk.
Interest rate risk refers to the risk of interest rates changing unfavorably before the swap dealer
can lay off on an opposing counterparty the unplaced side of a swap with another counterparty.
Basis risk refers to the floating rates of two counterparties being pegged to two different indices.
In this situation, since the indexes are not perfectly positively correlated, the swap bank may not
always receive enough floating rate funds from one counterparty to pass through to satisfy the
other side, while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers
6. Briefly discuss some variants of the basic interest rate and currency swaps diagramed in the
chapter.
Answer: Instead of the basic fixed-for-floating interest rate swap, there are also zero-coupon-
for-floating rate swaps where the fixed rate payer makes only one zero-coupon payment at
7. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive
markets, what other explanations exist to explain the rapid development of the interest rate
swap market?
Answer: All types of debt instruments are not always available to all borrowers. Interest rate
8. Suppose Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 - 8.10 percent
annually against six-month dollar LIBOR for dollars and 11.25 - 11.65 percent annually against
six-month dollar LIBOR for British pound sterling. At what rates will Morgan Guaranty enter into
a $/£ currency swap?
Answer: Morgan Guaranty will pay annual fixed-rate dollar payments of 7.75 percent against
receiving six-month dollar LIBOR flat, or it will receive fixed-rate annual dollar payments at 8.10
9. A U.S. company needs to raise €50,000,000. It plans to raise this money by issuing dollar-
denominated bonds and using a currency swap to convert the dollars to euros. The company
expects interest rates in both the United States and the euro zone to fall.
a. Should the swap be structured with interest paid at a fixed or a floating rate?
b. Should the swap be structured with interest received at a fixed or a floating rate?
CFA Guideline Answer:
b. The U.S. company would receive the interest rate in dollars. Because it expects that the
*10. Assume a currency swap in which two counterparties of comparable credit risk each
borrow at the best rate available, yet the nominal rate of one counterparty is higher than the
other. After the initial principal exchange, is the counterparty that is required to make interest
payments at the higher nominal rate at a financial disadvantage to the other in the swap
agreement? Explain your thinking.
Answer: Superficially, it may appear that the counterparty paying the higher nominal rate is at a
disadvantage since it has borrowed at a lower rate. However, if the forward rate is an unbiased
PROBLEMS
1. Alpha and Beta Companies can borrow for a five-year term at the following rates:
Alpha Beta
Moody’s credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
a. Calculate the quality spread differential (QSD).
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in
their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt.
No swap bank is involved in this transaction.
Solution:
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
LIBOR + 1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is
done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25%
savings over issuing floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% +
10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.
2. Do problem 1 over again, this time assuming more realistically that a swap bank is involved
as an intermediary. Assume the swap bank is quoting five-year dollar interest rate swaps at
10.7% - 10.8% against LIBOR flat.
Solution: Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at
LIBOR + 1%. Alpha will receive 10.7% from the swap bank and pay it LIBOR. Beta will pay
3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue
FRNs at six-month LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its
asset structure, three-month LIBOR is the preferred index. Company B is an A-rated firm that
also desires to issue five-year FRNs. It finds it can issue at six-month LIBOR + 1.0 percent or at
three-month LIBOR + .625 percent. Given its asset structure, six-month LIBOR is the preferred
index. Assume a notional principal of $15,000,000. Determine the QSD and set up a floating-
for-floating rate swap where the swap bank receives .125 percent and the two counterparties
share the remaining savings equally.
Solution: The quality spread differential is [(Six-month LIBOR + 1.0 percent) minus (Six-month
LIBOR + .125 percent) =] .875 percent minus [(Three-month LIBOR + .625 percent) minus
(Three-month LIBOR + .125 percent) =] .50 percent, which equals .375 percent. If the swap
basis, Company B will remit to the swap bank six-month LIBOR + .125 percent and pay three-
month LIBOR + .625 percent on its FRNs. It will receive three-month LIBOR - .125 percent from
the swap bank. This arrangement results in an all-in cost of six-month LIBOR + .825 percent,
which is a rate .125 percent below the FRNs indexed to six-month LIBOR + 1.0 percent
*4. A corporation enters into a five-year interest rate swap with a swap bank in which it agrees
to pay the swap bank a fixed rate of 9.75 percent annually on a notional amount of €15,000,000
and receive LIBOR. As of the second reset date, determine the price of the swap from the
corporation’s viewpoint assuming that the fixed-rate side of the swap has increased to 10.25
percent.
Solution: On the reset date, the present value of the future floating-rate payments the
corporation will receive from the swap bank based on the notional value will be €15,000,000.
5. DVR, Inc. can borrow dollars for five years at a coupon rate of 2.75 percent. Alternatively, it
can borrow yen for five years at a rate of .85 percent. The five-year yen swap rates are .64--.70
percent and the dollar swap rates are 2.41--2.44 percent. The current ¥/$ exchange rate is
87.575. Determine the dollar AIC and the dollar cash flow that DVR would have to pay under a
currency swap where it borrows ¥1,750,000,000 and swaps the debt service into dollars. This
problem can be solved using the excel spreadsheet CURSWAP.xls.
the yen debt service. The output from using the excel spreadsheet CURSWAP.xls is:
Cross-Currency Swap Analyzer
FC Bond
FC
$
Actual
Year
Cashflow
Received
Paid
$ Cashflow
0
1,750,000,000
-1,768,027,402
20,188,723
19,982,872
1
-14,875,000
14,875,000
-492,605
-492,605
2
-14,875,000
14,875,000
-492,605
-492,605
3
-14,875,000
14,875,000
-492,605
-492,605
4
-14,875,000
14,875,000
-492,605
-492,605
5
-
1,764,875,000
1,764,875,000
-20,681,328
-
20,681,328
AIC
0.85%
0.64%
2.44%
2.66%
Face Value:
1,750,000,000
Bid
Ask
Coupon Rate:
0.850%
Spot FX Rate:
87.57500
87.57500
OP as % of
Par:
100.000%
FC Swap Rate:
0.64%
0.70%
Underwriting
Fee:
0.000%
$ Swap Rate:
2.41%
2.44%
6. Karla Ferris, a fixed income manager at Mangus Capital Management, expects the current
positively sloped U.S. Treasury yield curve to shift parallel upward.
Ferris owns two $1,000,000 corporate bonds maturing on June 15, 2017, one with a
variable rate based on 6-month U.S. dollar LIBOR and one with a fixed rate. Both yield 50 basis
points over comparable U.S. Treasury market rates, have very similar credit quality, and pay
interest semi-annually.
Ferris wished to execute a swap to take advantage of her expectation of a yield curve shift
and believes that any difference in credit spread between LIBOR and U.S. Treasury market
rates will remain constant.
a. Describe a six-month U.S. dollar LIBOR-based swap that would allow Ferris to take
advantage of her expectation. Discuss, assuming Ferris’ expectation is correct, the change in
the swap’s value and how that change would affect the value of her portfolio. [No calculations
required to answer part a.]
Instead of the swap described in part a, Ferris would use the following alternative derivative
strategy to achieve the same result.
b. Explain, assuming Ferris’ expectation is correct, how the following strategy achieves the
same result in response to the yield curve shift. [No calculations required to answer part b.]
Settlement Date Nominal Eurodollar Futures Contract Value
12-15-15 $1,000,000
03-15-16 1,000,000
06-15-16 1,000,000
09-15-16 1,000,000
12-15-16 1,000,000
03-15-17 1,000,000
c. Discuss one reason why these two derivative strategies provide the same result.
CFA Guideline Answer
a. The Swap Value and its Effect on Ferris’ Portfolio
Because Karla Ferris believes interest rates will rise, she will want to swap her $1,000,000
fixed-rate corporate bond interest to receive six-month U.S. dollar LIBOR. She will continue to
hold her variable-rate six-month U.S. dollar LIBOR rate bond because its payments will increase
To execute this swap, she would enter into a two-year term, semi-annual settle, $1,000,000
nominal principal, pay fixed-receive floating U.S. dollar LIBOR swap. If rates rise, the swap’s
mark-to-market value will increase because the U.S. dollar LIBOR Ferris receives will be higher
than the LIBOR rates from which the swap was priced. If Ferris were to enter into the same
b. Eurodollar Futures Strategy
The appropriate futures hedge is to short a combination of Eurodollar futures contracts with
different settlement dates to match the coupon payments and principal. This futures hedge
accomplishes the same objective as the pay fixed-receive floating swap described in Part a. By
discussing how the yield-curve shift affects the value of the futures hedge, the candidate can
show an understanding of how Eurodollar futures contracts can be used instead of a pay fixed-
receive floating swap.
Why the Derivative Strategies Achieve the Same Result
Arbitrage market forces make these two strategies provide the same result to Ferris. The
two strategies are different mechanisms for different market participants to hedge against
increasing rates. Some money managers prefer swaps; others, Eurodollar futures contracts.
Each institutional market participant has different preferences and choices in hedging interest
rate risk. The key is that market makers moving into and out of these two markets ensure that
As more and more market makers sold Eurodollar futures contracts, the selling pressure
would cause their prices to fall and yields to rise, which would cause the present value cost of
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
rates would fall until the two rates converge. At this point, the arbitrage opportunity would no
longer exist and the swap and forwards/futures markets would be in equilibrium.
7. Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to
manage the company’s financial risks.
Two years ago, Rone issued a $25 million (U.S.$), five-year floating rate note (FRN). The
FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-
callable and will be repaid at par at maturity.
Scott expects interest rates to increase and she recognizes that Rone could protect itself
against the increase by using a pay-fixed swap. However, Rone’s Board of Directors prohibits
both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed
swap using a combination of capital market instruments.
a. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the
required transactions.
b. Explain how the transactions in Part a are equivalent to using a pay-fixed swap.
CFA Guideline Answer
a. The instruments needed by Scott are a fixed-coupon bond and a floating rate note (FRN).
The transactions required are to:
b. At the outset, Rone will issue the bond and buy the FRN, resulting in a zero net cash flow at
initiation. At the end of the third year, Rone will repay the fixed-coupon bond and will be repaid
the FRN, resulting in a zero net cash flow at maturity. The net cash flow associated with each
8. A company based in the United Kingdom has an Italian subsidiary. The subsidiary
generates €25,000,000 a year, received in equivalent semiannual installments of €12,500,000.
The British company wishes to convert the euro cash flows to pounds twice a year. It plans to
engage in a currency swap in order to lock in the exchange rate at which it can convert the
euros to pounds. The current exchange rate is €1.5/£. The fixed rate on a plain vanilla
currency swap in pounds is 7.5 percent per year, and the fixed rate on a plain vanilla currency
swap in euros is 6.5 percent per year.
a. Determine the notional principals in euros and pounds for a swap with semiannual payments
that will help achieve the objective.
b. Determine the semiannual cash flows from this swap.
CFA Guideline Answer
a. The semiannual cash flow must be converted into pounds is €25,000,000/2 = €12,500,000.
In order to create a swap to convert €12,500,000, the equivalent notional principals are
9. Ashton Bishop is the debt manager for World Telephone, which needs €3.33 billion Euro
financing for its operations. Bishop is considering the choice between issuance of debt
denominated in:
• Euros (€), or
• U.S. dollars, accompanied by a combined interest rate and currency swap.
a. Explain one risk World would assume by entering into the combined interest rate and
currency swap.
Bishop believes that issuing the U.S.-dollar debt and entering into the swap can lower
World’s cost of debt by 45 basis points. Immediately after selling the debt issue, World would
swap the U.S. dollar payments for Euro payments throughout the maturity of the debt. She
assumes a constant currency exchange rate throughout the tenor of the swap.
Exhibit 1 gives details for the two alternative debt issues. Exhibit 2 provides current
information about spot currency exchange rates and the 3-year tenor Euro/U.S. Dollar currency
and interest rate swap.
Exhibit 1
World Telephone Debt Details
Characteristic
Euro Currency Debt
U.S. Dollar Currency Debt
Par value
€3.33 billion
$3 billion
Term to maturity
3 years
3 years
Fixed interest rate
6.25%
7.75%
Interest payment
Annual
Annual
Exhibit 2
Currency Exchange Rate and Swap Information
Spot currency exchange rate
$0.90 per Euro ($0.90/€1.00)
3-year tenor Euro/U.S. Dollar
fixed interest rates
5.80% Euro/7.30% U.S. Dollar
b. Show the notional principal and interest payment cash flows of the combined interest rate
and currency swap.
Note: Your response should show both the correct currency ($ or €) and amount for each cash
flow.
Answer problem b in the template provided below:
Cash Flows
of the Swap
Year 0
Year 1
Year 2
Year 3
World pays
Notional principal
Interest payment
World receives
Notional principal
Interest payment
c. State whether or not World would reduce its borrowing cost by issuing the debt denominated
in U.S. dollars, accompanied by the combined interest rate and currency swap. Justify your
response with one reason.
CFA Guideline Answer
a. World would assume both counterparty risk and currency risk. Counterparty risk is the risk
that Bishop’s counterparty will default on payment of principal or interest cash flows in the swap.
b.
Year 0
Year 1
Year 2
Year 3
World pays
Notional
Principal
$3 billion
€3.33 billion
Interest payment
€193.14 million1
€193.14 million
€193.14 million
World receives
Notional
Principal
$3.33 billion
€3 billion
Interest payment
$219 million2
$219 million
$219 million
c. World would not reduce its borrowing cost, because what Bishop saves in the Euro market,
she loses in the dollar market. The interest rate on the Euro pay side of her swap is 5.80
MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It
has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to
manufacture microwave ovens for sale in the European Union. The plant is expected to cost
€5,500,000, and to take about one year to complete. The plant is to be financed over its
economic life of eight years. The borrowing capacity created by this capital expenditure is
$2,900,000; the remainder of the plant will be equity financed. Centralia is not well known in the
Spanish or international bond market; consequently, it would have to pay 7 percent per annum
to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of
equivalent risk is 6 percent. Alternatively, Centralia can borrow dollars in the U.S. at a rate of 8
percent.
Study Questions
1. Suppose a Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a
capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate
in the United States for dollars, whereas it can borrow euros at 6 percent. The exchange rate
has been forecast to be $1.33/€1.00 in one year. Set up a currency swap that will benefit each
counterparty.
*2. Suppose that one year after the inception of the currency swap between Centralia and the
Spanish MNC, the U.S. dollar fixed-rate has fallen from 8 to 6 percent and the euro zone fixed-
rate for euros has fallen from 6 to 5.50 percent. In both dollars and euros, determine the market
value of the swap if the exchange rate is $1.3343/€1.00.
Suggested Solution to The Centralia Corporation’s Currency Swap
1. The Spanish MNC should issue €2,180,500 of 6 percent fixed-rate debt and Centralia
should issue $2,900,000 of fixed-rate 8 percent debt, since each counterparty has a relative
comparative advantage in their home market. They will exchange principal sums in one year.
*2. The market value of the dollar debt is the present value of a seven-year annuity of
$232,000 and a lump sum of $2,900,000 discounted at 6 percent. This present value is
