Where do Swaps Fit into Your Company’s Portfolio?

This is part 10 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 9, we discussed regulation affecting swaps. In part 10, we’ll review the effectiveness of swaps and whether or not they should be used part of a hedging strategy.

Over the course of the series on interest rate swaps, we’ve reviewed the beginning s of swaps, different types of swaps, some examples of how swaps are used, special types of swaps used by central banks, and how swaps have impacted trends in regulation. In sum, it is an obvious conclusion that swaps are an integral part of financial markets, with estimates suggesting the depth of the market could be as little as $300 trillion to as great as $700 trillion  (the Bank of International Settlements pegs the dept at $415.2 trillion, as of 2006).

Although recent regulation (as discussed in part 9) could hurt the swaps market by removing some of the anonymous pricing mechanisms the OTC market provides, as well as thin out already thin exotic markets, it is unlikely that regulation clamps down on derivatives further unless there is a major financial crash involving swaps again, much like the U.S. housing crash in 2007/2008. Considering the vast amount of liquidity added to financial markets since the 2007/2008 crash (totaling several trillions of dollars), it is unlikely that such an event happens over the coming years.

We’ve also discussed the comparative advantage that comes with hedging via swaps: risks to profits can be reduced through the two main types of swaps, currency swaps and interest rate swaps. In part 6, we showed how Coca-Cola could access cheaper borrowing costs when looking abroad, and how through currency swaps, it was able to hedge away its foreign exchange rate volatility risk. Similarly, through interest rate swaps and forwards, JPMorgan was able to reduce risk transferred to it from Coca-Cola. Just like these theoretical companies, any company can use swaps to limit risk taking.

It should be noted that there are potential caveats to swaps. If a fixed rate is swapped for a floating rate, a rise in interest rates over the contract life could result in higher debt servicing costs. If interest rates are volatile from year to year (they tend not to be anymore among developed economies like Germany, Japan, the United Kingdom, and the United States), this could result in high profits one year or low profits in another.

If a floating rate is swapped for a fixed rate, the reverse can be said: while the party with the fixed rate is protected from interest rate volatility, it misses out on the opportunity to profit from the shifting rate environment. Through proper risk management using a tool like myHedgebook, these problems can easily be avoided:

Instant fair value (mark-to-market) calculations for your transactions and sensitivity reporting remove the manual elements of complying with accounting standards such as IFRS7 and IAS39, and remove the reliance on your bank for fair values.

Sensitivity reporting also plays a valuable role in management of a portfolio by clearly demonstrating the effect that shifts in interest rates would have on the P&L.

Capturing a swap in Hedgebook is a simple process, with the entry of all of the key parameters of in a single deal input screen. Here the face value, maturity date, reset frequency accrual basis and coupon rate and coupon margins are entered and the swap is saved.

Hedgebook supports multiple variations of accrual basis, reference rate, business day conventions and swap curves to match the exact parameters of your particular swap.

Once saved, the interest rate swap can be valued at any time based on Hedgbook’s daily rate feeds.

Try Hedgebook free for 30 days. Click here to start your trial today!

The Future of Interest Rate Swaps: Will Regulation Kill this Investment Vehicle?

This is part 9 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 8, we discussed the role of interest rate swaps in the demise of Greece. Given the importance of swaps in the U.S. housing crash, new regulation has arisen that could threaten the future of this important financial derivative.

In late-2008, financial markets were a mess: credit markets had dried up; equity markets plummeted, eliminating trillions of dollars of wealth from the economy; and politicians needed someone to blame. Given the fact that a series of complex transactions involving swaps ultimately accentuated the market crash, OTC derivatives, specifically swaps, were an easy target.

With public outcry high for a scapegoat, U.S. Congressmen and Congresswomen called for action to regulate OTC derivatives, what the Bank of International Settlements has characterized as a $415.2 trillion market. Led by House Financial Services Committee Chairman Barney Frank, new regulations were set forth in December 2009 to curb risk tanking by large financial institutions. Regulations focused on two main issues:

  1. Should financial institutions have ownership in swaps clearinghouses? Should ownership be limited? A conflict of interest may arise provoking riskier activities if not addressed properly.
  2. Should regulators have the power to set capital and margin requirements for non-financial participants in the swaps market? Would this regulation result in lower market participation rates, thus creating a premium for liquidity?

When the Dodd-Frank Act (named after Senator Christopher Dodd and Representative Barney Frank, the chief architects) was signed into law by President Barack Obama in July 2010, many of the large financial institutions operating within the OTC market were forced to sell off operations involving swaps deemed uncritical to their in-house hedging operations; or the arms of the financial institutions trading in swaps markets for speculative purposes were forced to close. Additionally, OTC derivatives trading would be funneled through clearinghouses and exchanges for greater accountability.

Financial Scholars Group published perhaps the best perspective on the Dodd-Frank Act in July 2012:

Dodd-Frank legislation was passed in 2010 to overhaul the financial market with the objective of removing or alleviating systemic deficiencies. With respect to OTC IR swaps, Dodd-Frank seeks to lower systemic risk through centralized clearing of trades, better risk management, and trade reporting transparency. Yet despite its size, the IR swap market is small in important respects. Any policy attempting to address a market hundreds of trillions of dollars in size must also take into account that in some ways the swap market is quite nuanced, with some IR swaps trading very thinly and thus potentially substantially disrupted by even finely tuned regulatory policies.

FSG continued to say, “In thin markets disclosing deal terms can have the opposite effect. This is because statistical data is no longer anonymous. With a small number of trades, parties can potentially make inferences about the investment strategies of others. Thus, trade data for thin markets can have an undesirable, amplified signaling effect revealing the market expectations of some participants.”

Given these observations, we can draw a few necessary conclusions: first, OTC derivatives markets, especially those related to swaps, are under a microscope, especially in the United States. Second, a fundamental lack of understanding by legislators could lead to overregulation, diminishing the effectiveness of interest rate swaps (and other variations of swaps) as hedges.

Over the next few years, it is unlikely that regulation comes down hard on the OTC derivatives market barring a major financial crash with swaps at the center once more. This is a far-fetched outcome going forward, considering that loose monetary policies across the globe have introduced trillions of dollars of liquidity over the past few years, driving down borrowing rates in both developed and developing economies. As such, and in light of the increased globalized nature of financial markets in contemporary times, swaps will remain an important financial instrument for years to come.

In part 10 of 10 of this series, we’ll talk about the role of swaps in your company’s hedge portfolio and why, despite the bad rap they get from the U.S. housing crisis, the Goldman Sachs-Greece debacle, and political posturing, swaps remain an integral and important part of global financial markets

The Euro-zone Crisis: Goldman Sachs, Greece, and Swaps

This is part 8 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 8, we’ll discuss the role of swaps in more recent times: the Euro-zone crisis.

In June 2001, seeking to shore up its finances as it prepared to use the Euro as a member of the Euro-zone currency union, Greece reached a deal with the U.S. bank Goldman Sachs to borrow €2.8 billion.  When the deal was reached, the Greek government had already owed Goldman Sachs about €600 million – not counting the €2.8 it just borrowed.

Just four years later, the costly transaction nearly doubled to €5.1 billion. It turns out that a currency swap agreement was in place to help conceal Greece’s haphazardly constructed balance sheet, which showed that the country was experiencing an unsustainable rise in its debt-to-GDP ratio. Without the deal, Greece wouldn’t have been able to join the Euro-zone, as its debt-to-GDP ratio was in breach of the European Union’s rules for the amount of debt each country could have in order to join the Euro. But a loophole in the law allowed the currency swap agreement in place to not be counted as debt, thereby keeping Greece’s debt-to-GDP ratio within the European Union’s required range.

The arrangement made in June 2011 had two key components. The first was a series of currency swaps. Greece’s debt, which historically was accounted for in Japanese Yen and U.S. Dollars, was converted to Euros for the transition into the common market. Instead of the contracts being transacted at the spot exchange rate, they were measured against a fake exchange rate devised by the Greek government and Goldman Sachs – a perfectly legal move, given accounting rules in the European Union at the time.

Because of the positive value that currency swaps had for Greece, the government needed to pay back what was, for all intents and purposes, a loan from Goldman Sachs. In a separate deal, Greece entered into an interest rate swap which yielded a positive value of €2.8 billion to Goldman Sachs, including €400 million in fees for unwinding other swaps Greece had entered. In its truest sense, this was a fixed-for-floating swap: Greece would send floating-rate payments to Goldman until 2019, while Goldman Sachs would happily send fixed-rate payments to Greece.

Perhaps the best analogy for what happened to Greece is what happened with the U.S. housing crisis. Part of the deal with Goldman Sachs was a two-year period in which Greece would not have to make any payments, similar to what is the teaser rate period. As history showed, without the benefit of rising housing prices, subprime borrowers couldn’t refinance within the teaser window (in which rates were low before springing to unsustainably high levels, hence the housing crash).

Like the teaser loan rates enjoyed by subprime borrowers in the U.S., the payment-free period enjoyed by Greece made it seem like the country’s finances were fine, because the country didn’t have any debt obligations for two-years. Instead of hoping for rising house prices, the Greek government was hoping that an economic boom would spur higher tax receipts, which the government could use to pay down the cost of the currency swap.

While the Greek government enjoyed low borrowing costs, the repercussions were building on the horizon: the deferred interest would have to be paid eventually. In 2005, as noted earlier, Greece was forced to refinance the loan, bringing the total cost of the deal to €5.1 billion. This “actively managed tweak,” as described by Eurostat, allowed Greece to keep the loan a secret, thereby keeping its debt-to-GDP ratio within the European Union’s mandated range. After Greece refinanced its debt, Goldman Sachs sold its obligation to the National Bank of Greece, at a marked-to-market value of €5.1 billion.

But these are just large numbers – why do they actually matter? When Greece initiated the original transaction with Goldman Sachs, it had publicly issued 10-year bonds with a coupon rate of 5.35%. Some quick math: compounding this rate over four years (to 2005), Greece would have owed €3.4 billion; instead, the €5.1 billion obligation represented an astounding 16.3% (!) annual interest rate.

Instead of bringing this issue to light immediately, the government chose to hide the mistake further, extending the maturity of the loan another 18 years to 2037. But by 2010, the costly repayments were too much to handle, and Greece was forced to reinstate the debt onto its balance sheet: the Greek debt crisis was born. Today, it is widely expected that Greece will default on its >€300 billion of obligations, forcing it out of the Euro-zone and back to using the Drachma, Greece’s pre-Euro currency.

In part 9 of 10 of this series, we’ll discuss recent regulatory efforts as a direct result of costly mistakes that have piled up over the past several years directly related to swaps.

 

Understanding Central Bank Liquidity Swaps

This is part 7 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 7, we illustrated how companies use swaps in the global market place, but on a company-to-company basis. In part 8, we’ll explain the purpose of swaps on the central bank level and when they’re used.

As established earlier in this series, a currency swap is an agreement to exchange principal interest and fixed interest in one currency (i.e. the U.S. Dollar) for principal interest and fixed interest in another currency (i.e. the Euro). Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Banks and companies aren’t the only parties using currency swaps. A special type of currency swap, a central bank liquidity swap, is utilized by central banks (hence the name) to provide their domestic country’s currency (i.e. the Federal Reserve using the U.S. Dollar) to another country’s central bank (i.e. the Bank of Japan).

Central bank liquidity swaps are a new instrument, first deployed in December 2007 in agreements with the European Central Bank and the Swiss National Bank as U.S. Dollar funding markets ‘dried up’ overseas. The Federal Reserve created the currency swap lines to assist foreign central banks with the ability to provide U.S. Dollar funding to financial institutions during times of market stress. For example, if the Federal Reserve were to open up liquidity swaps with the Bank of Japan, the Bank of Japan could provide U.S. Dollar funding to Japanese banks (just as the Bank of England would provide liquidity to British banks, etc).

As the world’s most important central bank (next to the Bank of International Settlements, considered the central bank for central banks) in one of the world’s most globalized financial markets, the Federal Reserve has a responsibility of keeping safe financial institutions under its jurisdiction. Thus, when factors abroad (such as the European sovereign debt crisis) create funding stresses for U.S. financial institutions, the Federal Reserve, since 2007, has opened up temporary swap lines.

Generally speaking, currency liquidity swaps involve two transactions. First, like currency swaps between banks and companies (as illustrated in part 7), when a foreign central bank needs to access U.S. Dollar funding, the foreign central bank sells a specified amount of its currency to the Federal Reserve in exchange for U.S. Dollars at the current spot exchange rate.

In the second transaction, the Federal Reserve and the foreign central bank enter into agreement that says the foreign central bank will buy back its currency at a specified date at the same exchange rate for which it exchanged them for U.S. Dollars. Additionally, the foreign central bank pays the Federal Reserve interest on its holdings.

Unlike regular currency swaps, central bank liquidity swaps are rare and only occur during times of market stress. The first such occurrence, as noted earlier, was in December 2007, as funding markets started to dry up as the U.S. economy entered a recession as the housing market crashed.

More recently, on November 30, 2011, the Federal Reserve announced liquidity swaps with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank, after the European sovereign debt crisis roiled markets throughout the fall. These swaps are set to expire in February 2013.

What necessitated the Federal Reserve’s most recent round of central bank liquidity swaps? The ongoing crisis in Greece, which in fact was onset by a series of ill-advised interest rate swaps with U.S. bank Goldman Sachs.

In part 8 of 10 of this series, we’ll discuss the role of interest rate swaps in more recent times: the Euro-zone crisis (as well as answer the question in part 5 about Goldman Sach’s role with Greece’s demise).

Real World Example: Swaps Between Companies

This is part 6 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 6, we’ll provide a real world example of how swaps are constructed and executed.

We’ve discussed the workings of swaps on a very basic level at this point (parts 1 through 4) and even covered some of the basic questions asked by those seeking information on swaps and their function in the economy (part 5), but we have yet to outline a real world example of how two parties might initiate a swap (for the case of making a point, the yields discussed henceforth are theoretical and not tied to current market rates).

In this example, we’ll discuss how a company, Coca-Cola, would approach a bank, JPMorgan, to initiate a swap, and given the concept of a comparative advantage, both parties would ultimately benefit from a swap.

Example:

Coca-Cola needs to raise $150 million for transactions over the next 5 years. In the United States, Coca-Cola is able to borrow $150 million at an interest rate of 4.50%, or 100-basis points above the 5-year U.S. Treasury Note (3.50%). However, outside of the United States, it is able to borrow at 4.20%, or 70-basis points above the 5-year U.S. Treasury Note. Thus, there is an incentive for Coca-Cola to seek funding outside of the United States so as to reduce its borrowing costs.

It turns out that outside of the United States, there is strong demand for non-U.S. Dollar bond issues, thus creating the necessity for Coca-Cola to issue debt in a currency other than U.S. Dollars. With New Zealand zero-coupon issues selling well in Europe at the time of its financing needs, Coca-Cola issues a N$367 million zero-coupon, 5-year Eurobond. With the New Zealand Dollar interest rate at 8%:

At the rates used in this example, Coca-Cola would thus take N$250 million of proceeds, or 68%, of its N$367 million issuance. Now Coca-Cola can easily obtain its desired $150 million by converting the N$250 million at the prevailing $/N$ rate of 0.6000.

But wait? Doesn’t this leave Coca-Cola exposed to currency fluctuations? Yes – which is why swaps come into play as a hedge against risks.

Instead of simply converting its proceeds, Coca-Cola enters into a 5-year swap agreement with JPMorgan, swapping the N$267 million for the desired $150 million. Accordingly, given the parameters of this example, Coca-Cola would pay JPMorgan 4.20% over the life of the contract. When the contract matures, Coca-Cola would swap $150 million for N$267 million; and now Coca-Cola has eliminated its exposure to exchange rate fluctuations.

What about JPMorgan? The bank now bears the currency risk, so it must hedge as well. JPMorgan must find a New Zealand bank (or any counterparty) that is willing to make a swap U.S. Dollars for New Zealand Dollars.

JPMorgan and Rabobank agree to a swap contract, with JPMorgan making annual payments of LIBOR -50-basis points. However, Rabobank cannot take on the full N$267 million. Instead, it can only swap N$200 million, meaning JPMorgan still has currency exposure of N$67 million. JPMorgan can exchange its N$67 million in the foreign exchange spot market for $40 million.

To protect itself from further risk, JPMorgan would have to agree to a forward contract with Rabobank, exchanging its $40 million 5-years out at a predetermined rate. By using forwards, JPMorgan insulates itself from currency fluctuations entirely, given this example. Interest rate risks still exist (from the obligation to Rabobank), so it would thus enter into an interest rate swap with another bank that’s willing to exchange a floating rate for JPMorgan’s fixed rate.

Conclusion: both Coca-Cola and JPMorgan were able to hedge away their risks via a series of currency swaps and interest rate swaps, reducing potential losses to both company’s balance sheets and shareholders. Without swaps, Coca-Cola would be at risk of exchange rate fluctuations, likely forcing it to pay a higher borrowing cost than it otherwise would have.

In part 7 of 10 of this series, we will lay out the importance of currency swaps not on a micro level (company-to-company), but on a macro level (between central banks).

Swaps: A basic Q and A

This is part 5 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 5, we’ll review the basics before looking at some real world examples in parts 6 and 7.

We’ve fielded some basic questions on interest rate swaps and will provide some clear, succinct answers to make this complex financial instrument a little more understandable.

What is a swap?

A swap is a financial derivative in which two parties (called counterparties) exchange future cash flows of the first party’s financial instrument for the future cash flows of the second party’s financial instruments.

What is the most common type of swap?

The most common type of swap is a plain vanilla swap, or an interest rate swap, and is when one party exchanges its fixed rate obligation with a second party’s floating rate obligation. Currency swaps, sometimes referred to as cross-currency swaps, are also very common, especially in the realm of international financing.

I only recently heard of swaps, how long have they been around for?

The first swap, a currency swap, was a $290 million agreement between the World Bank and IBM, in 1981.

How big is the swap market now?

As the world’s deepest financial derivatives market, the over-the-counter (OTC) swaps market has a notional value of $415.2 trillion as of 2006, according to the Bank of International Settlements (sometimes referred to as the central bank for central banks). At that figure, in 2006 dollars, that would make the swaps market approximately 8.5 times the size of global GDP – combined!

Over-the-counter, what does that mean?

Over-the-counter, or OTC, is off-exchange trading of financial instruments, not just swaps, but stocks, bonds, and commodities as well, directly between parties. While most of the swaps market is OTC, meaning it is without a centralized exchange, interest rate swaps can be standardized contracts regulated by exchanges, like futures.

Who uses swaps?

Swaps are utilized by two groups of people: hedgers and speculators. Bona fide hedgers are using swaps to insulate themselves from future risk, whereas speculators are without hedging need and are in the market for the sake of making money. Under CFTC Regulation 1.3(z), no transactions or position will be classified as bona fide hedging unless their purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established and liquidated in an orderly manner in accordance with sound commercial practices.

So bona fide hedgers come from futures trading?

No! Actually, the first hedge exemption was granted by the CFTC to a swaps dealer for OTC index-based exposure where the swaps dealer writing the swap establishes a futures position to hedge its price exposure on the swap. Sounds complicated, but really, the swaps dealer proved he was protecting his capital rather than using it to speculate on swaps.

I have a fixed rate but I really want a floating rate – what do I do?

If your financing is within your borders and you are using your domestic currency, a domestic fixed-for-floating swap is the type of swap you would initiate with another party. This is known as a plain vanilla swap (see above), and is the most common type of swap.

But I’m not using these funds in my country – I’m funding a project aboard

In this case, this would be a fixed-for-floating currency swap, or a cross-currency swap, and it would require a counterparty in the country in which you’re seeking to finance a project.

I remember where I’ve heard swaps before – didn’t Greece get in trouble with swaps?

This is a complicated subject but we will cover it extensively in part 8 of this series.

In part 6 of 10 of this series, we will lay out simple real world examples of how companies would use swaps to hedge against risk in domestic projects as well as projects abroad.

Floating-for-Floating and Fixed-for-Fixed Swaps: Domestic and Foreign Currency Transactions

This is part 4 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 and 2, we discussed the beginnings of swaps as well as the differences between interest rate swaps and currency swaps. In part 3, we discussed fixed-for-floating swaps. In part 4, we’ll discuss floating-for-floating and fixed-for-fixed swaps.

In the first 3 parts of this series on interest rate swaps and their role in the global economy, we’ve covered the broader strokes of interest rate swaps and currency swaps, with our most recent discussion focusing on fixed-for-floating swaps, or plain vanilla swaps. While similar, fixed-for-fixed swaps are slightly different from their plain vanilla counterpart.

Floating-for-floating rate swaps can be used to limit risk associated with two indexes fluctuating in value. For example, if company A has a floating rate loan at JPY 1M LIBOR and it has a floating rate investment that yields JPY 1M TIBOR + 60-basis points and currently the JPY 1M TIBOR is equal to JPY 1M LIBOR + 20-basis points. Given these metrics, company A has a current profit of +80-basis points. If company A thinks that JPY 1M TIBOR will decrease relative to the LIBOR rate or that JPY 1M LIBOR is going to increase relative to the TIBOR rate, it would initiate a floating-for-floating swap to hedge against downside risk.

Company A finds company B in a similar situation, each finding a comparable advantage to a floating-for-floating swap. Company A can swap JPY TIBOR + 60-basis points and receive JPY LIBOR + 70-basis points. By doing so, company A has effectively locked in profit of 70-basis points instead of holding +80-basis points unprotected to volatility in the base indexes.

A fixed-for-fixed swap is fairly straight forward. Let’s say an American firm, company C, is able to take out a fixed rate loan in the U.S. at 8%, but needs a loan in Australian Dollars to finance a construction project in Australia. However, the interest rate for company C is 12% in Australia. Simultaneously, an Australian company, company D, can take out a fixed rate loan of 9%, but needs a loan in U.S. dollars to finance a construction project in the U.S., where the interest rate is 13%.

This is where a fixed-for-fixed currency swap comes into play: company C (in the U.S.) can borrow funds at 8% and lend the funds to the Australian company for 8%, while company D (in Australia) can borrow funds at 9% and lend the funds to the U.S. company for 9%. The comparable advantage is equal for both company C and company D: both save 4% they would have otherwise had to have spent without fixed-for-fixed currency swaps.

In part 5 of 10 of this series, we’ve fielded some basic questions on interest rate swaps and will provide some clear, succinct answers to make this complex financial instrument a little more ‘plain vanilla.’