Quantifying bank counterparty credit spread inputs for CVA

At Hedgebook we are often asked by our clients what the appropriate credit spreads are when calculating CVA (Credit Value Adjustment) under the current exposure method. The current exposure method requires a credit spread over the risk-free rate (swap rates) to determine the discount factor for future Cashflows. The current exposure method is appropriate for calculating credit adjustments for vanilla financial instruments such as foreign exchange forwards and options, and interest rate swaps. If your derivatives are in-the-money then the credit valuation adjustment quantifies the risk of your counterparty defaulting.

One appropriate source for quantifying appropriate credit spreads is the secondary bond market where bank/corporate bonds are traded amongst fixed income participants. The banks are active issuers into this market and as such provide a useful guide to how the market views their credit worthiness. By looking at spreads over swap we can derive a credit term structure to use in the calculation of CVA.

The following table shows the spread over swap for senior bank bonds in the NZ fixed income market. The data has been extracted using the January 2015 month-end corporate bond pricing information from one of the four Australian owned NZ registered trading banks.

  6 mths to
1 yr
1 to 2 yrs 2 to 3 yrs 3 to 4 yrs 4 to 5 yrs
ANZ 20 to 30 bp N/A 42 bp 52 to 59 bp 60 to 61 bp
ASB 22 bp N/A 41 to 50 bp 55 bp N/A
BNZ 21 bp N/A N/A 55 to 60 bp 63 bp
Westpac N/A N/A 41 bp 57 bp 64 bp

* bp = basis points per annum. 1bp = 0.01%

As each of these banks is rated AA- by S&P it is intuitive that their senior bonds trade within close proximity to each other. From the information we can generalise and build a credit term structure that can be plugged into valuation models to determine CVA. An estimated AA- credit curve could be:

  • 1 year = 25 bp
  • 2 year = 35 bp (linearly interpolated between 1 and 3 year points)
  • 3 year = 45 bp
  • 4 year = 55 bp
  • 5 year = 65 bp

The reality is that the CVA calculation is not very sensitive to these inputs so it is not necessary for a corporate with vanilla instruments to agonise over the credit assumptions. That said, the assumptions must be defensible and, more importantly from an IFRS 13 perspective, observable.

Furthermore, we would argue that if you are a corporate banked by more than one of the four banks in the table above then there is little added value in creating a curve for each counterparty. As we have shown, there is little difference in the market’s credit view between one AA- NZ bank and another.

The CVA module within the HedgebookPro app allows the user to create multiple credit curves and assign them appropriately to the relevant instruments. However, creating multiple curves will only be of added value if the counterparties are of materially different credit standing.

Credit spreads back to pre GFC levels

We have discussed CVA at length in our newsletter and blog as it is arguably the most significant change to the accounting standards, from a financial instruments valuation perspective, since hedge accounting was introduced. The standard relating to CVA, IFRS 13, was developed as a result of the Global Financial Crisis. It became apparent that credit risk had been mispriced for a long time in the lead up to the implosion of the credit markets in 2008/2009. IFRS 13 forces organisations to include an adjustment to financial instruments to represent a credit component – both for the reporting entity as well as the counterparty. The adjustment can be a reasonably immaterial number impacted by factors such as the remaining term to maturity and how far in- or out-of-the-money the derivatives are.

Some companies argue that the relative immateriality of the credit adjustment reduces the necessity of quantifying the credit component, to the extent that some companies are not bothering to do it. We understand that view as IFRS 13 seems like another regulatory requirement that adds little value to the business. However, the standard is explicit in its language that “fair value”, by definition, includes credit, therefore, the decision to do nothing about it cannot pass muster with the auditor.

A contributing factor to the “immateriality” argument is the prevailing benign credit conditions. The credit spread of banks can be observed through the Credit Default Swaps (“CDS”) market. A CDS is like an insurance policy – it compensates the holder of the policy if the underlying entity defaults on its debt obligations. As the chart below shows the credit quality of the big 4 Australian banks has been improving since the spike in 2011 and has continued to retrace back to levels that prevailed pre GFC. The resulting effect is to reduce the credit valuation impact on out-of-the-money derivatives (current exposure method). We would argue that although credit conditions have returned to benign levels it is only a matter of time before another credit shock occurs and companies will be better prepared to quantify such impacts if they already have a tried and tested methodology in place. Our Hedgebook clients benefit from the system’s low cost, easy to use CVA module.

Big 4 CDS 3 year

Lies, damned lies and valuations

With the passing of 30 June we have entered another busy period for year-end valuations. One of the most common questions we are asked at these important balance dates is “why is there a difference between the bank valuation and the Hedgebook valuation (or any other system’s valuation for that matter)?” The question is most commonly posed by auditors. It is probably not surprising that auditors want a perfect reconciliation between the client’s information and their own independent check but alas it will never come to pass. In this article we consider a selection of reasons that can lead to differences in valuations.

Although the modelling of interest rate swap valuations is relatively unchanged over many, many years there are subtle differences that will result in no two valuations being the same. From an interest rate swap perspective the most likely source of valuation differences is the construction of the zero curve. The zero curve is used to estimate the future cashflows of the floating leg of the swap, as well as the discount factors used to net present value the future values of the cashflows (both fixed and floating legs).

The underlying interest rate inputs into the zero curve construction (deposit rates, bank bills, LIBOR, futures, swap rates, etc.) may be slightly different between one system and another. Unlike official rate-sets such as BKBM, BBSW, LIBOR, EURIBOR, CDOR, etc. there is no one source for zero curves.

The mathematical technique to combine the various inputs into a zero curve can also differ (linear interpolation, cubic spline). These types of differences can lead to discrepancies between one valuation and another. Although on a percentage of notional basis the discrepancies are small, the monetary differences can become material if the notional of the swap is big enough i.e. a $500 difference on a $1 million interest rate swap becomes a $50,000 difference on a $100 million swap – a number that will draw attention but in reality is still immaterial.

The timing of the market snapshot for closing rates can be different, too. For example, Hedgebook uses New York 5pm as the end of day for valuation purposes, therefore, if the Hedgebook valuation is compared to a system that uses, say, Australia 5pm as its rate feed, then any movement in the intervening period will cause differences in valuations.

What we have talked about above is premised on the fact that two identical deals are being valued against each other. By far the most common reason for different valuations lies in human error around the inputting of a deal. From an interest rate swap perspective, the rate-set frequency (monthly, quarterly), accrual basis, business day conventions, margins on the floating leg are all possible areas which can result in valuation differences. The most common input error we come across relates to amortising interest rate swaps (changing face value and/or interest rate over the life of the swap). Very often there is no way for an auditor to realise that a swap is an amortising structure just by looking at the bank valuation. Often it is just the face value of the swap at the current valuation date that is shown on the bank valuation. It is the schedule at the end of the original bank confirmation that is required to accurately input and value such a structure.

Of course the true valuation of a derivative is determined by the price at which it can be sold/closed out which will be different to a valuation for accounting purposes. Valuations for accounting purposes are based on mid rates and, therefore, take no account of bid/offer spreads. Some of the changes we are seeing in the International Financial Reporting Standards are trying to provide greater consistency and more explicit definitions of fair value (IFRS 13). At least the “risk-free” component of an interest rate swap is a well-established methodology. The same cannot be said for the credit component (CVA), for which there is a myriad of approaches. It will be interesting to see how differences are reconciled and treated by auditors, as there is even less likelihood of two valuations being the same.

IFRS 13: Fair value measurement – Credit Value Adjustment

The purpose of this blog is to examine IFRS 13 as it relates to the Credit Value Adjustment (CVA) of a financial instrument. In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. IFRS 13 requires the valuation of counterparty credit risk to be quantified and separated from the risk-free valuation of the financial instrument. There are two broad methodologies that can be considered for calculating CVA: simple and complex. For a number of pragmatic reasons, when considering the appropriate methodology for corporates, the preference is for a simple methodology to be used, the rationale for which is set out below.

IFRS 13 objectives

Before considering CVA it is worthwhile re-capping the objectives of IFRS 13. The objectives are to provide:

–          greater clarity on the definition of fair value

–          the framework for measuring fair value

–          the disclosures required about fair value measurements.

Importantly, from a CVA perspective, IFRS 13 requires the fair value of a liability/asset to take into account the effect of credit risk, including an entity’s own credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Factors that influence credit risk

When considering credit risk there are a number of factors that can influence the valuation including:

–          time: the longer to the maturity date the greater the risk of default

–          the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity

–          collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced

–          netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced

CVA calculation: simple versus complex

There are two generally accepted methodologies when considering the calculation of CVA with each having advantages and disadvantages.

The simple methodology is a current exposure model whereby the Net Present Value (NPV) of the future cashflows of the financial instrument on a risk-free basis is compared to the NPV following the inclusion of a credit spread. The difference between the two NPVs is CVA.  The zero curve for discounting purposes is simply shifted by an appropriate credit spread such as that implied by observable credit default swaps.

Zero curve

To give a sense of materiality, a NZD10 million swap at a pay fixed rate of 4.00% with five years to maturity has a positive mark-to-market of +NZD250,215 based on the risk-free zero curve (swaps). Using a 200 basis point spread to represent the credit quality of the bank/counterparty the mark-to-market reduces to +NZD232,377. The difference of -NZD17,838 is the CVA adjustment. The difference expressed in annual basis point terms is approximately 3.5 bp i.e. relatively immaterial. In the example we have used an arbitrary +200 bp as the credit spread used to shift the zero curve. In reality the observable credit default swap market for the counterparty at valuation date would be used.

The advantages of the simple methodology is it is easy to calculate and easy to explain/demonstrate. The disadvantage of the simple methodology is takes no account of volatility or that a position can move between being an asset and a liability as determined by the outlook for interest rates/foreign exchange.

The complex methodology is a potential future exposure model and takes account of factors such as volatility (i.e. what the instrument may be worth in the future through Monte Carlo simulation), likelihood of counterparty defaulting (default probability) and how much may be recovered in the event of default (recovery rate). The models used under a complex methodology are by their nature harder to explain, harder to understand and less transparent (black box). Arguably the complex methodology is unnecessary for “less sophisticated” market participants such as corporate borrowers using vanilla products, but more appropriate for market participants such as banks.

Fit for purpose

An important consideration of the appropriate methodology is the nature of the reporting entity. For example, a small to medium sized corporate with a portfolio of vanilla interest rate swaps or Forward Exchange Contracts (FECs) should not require the same level of sophistication in calculating CVA as a large organisation that is funding in overseas markets and entering complex derivatives such as cross currency swaps. Cross currency swaps are a credit intensive instrument and as such the CVA component can be material.

Valuation techniques

Fair value measurement requires an entity to explain the appropriate valuation techniques used to measure fair value. The valuation techniques used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability. In other words, the reporting entity needs to be able to explain the models and inputs/assumptions used to calculate the fair value of a financial instrument including the CVA component. Explaining the valuations of derivatives including the CVA component is not a straightforward process, however, it is relatively easier under the simple methodology.

Summary

IFRS 13 requires financial instruments to be fair valued and provides much greater guidance on definitions, frameworks and disclosures. There is a requirement to calculate the credit component of a financial instrument and two generally accepted methodologies are available. For market participants such as banks, or sophisticated borrowers funding offshore and using cross currency swaps, there is a strong argument for applying the complex methodology. However, for the less sophisticated user of financial instruments such as borrowers using vanilla interest rate swaps or FECs then an easily explainable methodology that simply discounts future cashflows using a zero curve that is shifted by an appropriate margin that represents the counterparty’s credit should suffice.

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

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).

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.’

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

This is part 3 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’ll discuss fixed-for-floating swaps. 

Fixed for Floating Swaps

This is a chart provided in the March 1987 Federal Reserve paper “Interest Rate Swaps: Risk and Regulation,” by J. Gregg Whitataker. It remains perhaps the simplest and best diagram to date on how a fixed-for-floating swap works.

But before we jump into some math, we should reestablish the basic motivation behind swaps: comparable advantage. For example, if the party (party A) holding the floating rate instrument believes rates will increase in the short-term while the party (party B) holding the fixed rate instrument believes rates will decrease in the short-term, they might swap obligations. Thus, once the swap is complete, party A is ‘long the fixed rate, short the floating rate,’ while party B is ‘short the fixed rate, long the floating rate.’

The aforementioned example is a plain vanilla swap, a fixed-for-floating swap involving only one currency (i.e. a swap agreement involving two companies using the same domestic currency). Let’s say party A wants to take out a loan, at 12% and a floating rate of LIBOR +2% (but would really prefer a fixed rate). Conversely, party B wants to take out a loan, at 8% and a fixed rate of LIBOR +4% (but would really prefer a floating rate). By using a fixed-for-floating swap, both party A and party B can exchange obligations and receive their respective desired interest rates.

While fixed-for-floating swaps involving one currency are simple, they become slightly more complicated when involving more than one currency. As the name suggests, fixed-for-floating swaps in different currencies involve exchanging a fixed rate in one currency (i.e. U.S. Dollars) for a floating rate in another currency (i.e. Euros).

For example, if a company A has a fixed rate $50 million loan at 6.5% paid monthly and a floating rate investment of €75 billion that yields EUR 1M LIBOR +75-basis points monthly, and is worried about exchange rate fluctuations, it may choose to enter a fixed-for-floating currency swap with another firm, company B. In this example, company A wants to ensure profit in U.S. Dollars as they expect one of two things to occur: either the EURUSD exchange rate to drop; or the EUR 1M LIBOR to drop. By entering a fixed-for-floating currency swap with company B, paying EUR 1M LIBOR +75-basis points and receiving a 7.0% fixed rate, company A secures 50-basis points of profit and reduces its interest rate exposure.

In part 4 of 10 of this series, we’ll discuss floating-for-floating and fixed-for-fixed swaps.