Chapter 8

Interest Rate
Swaps

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 Key Focus Areas

How does Interest Rate Risk How to manage interest

arise? Rate Risk?

What are the different Application Focus: Management of

types of Interest Rate Interest Rate Risk using a Forward
Swaps? Rate Agreement (Tutorial focus)

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 Interest Rate Foundation
• All firms – domestic or multinational, small or large, leveraged or
unleveraged are sensitive to changes in interest rates.

• The global financial market place is defined both by exchange rates and
interest rates. Chapter 8 essentially talks about the interest rate structures
and challenges of a firm operating in a multi currency interest rate world.

• A reference rate, for e.g. US dollar LIBOR is the rate of interest used in a
standardized quotation, loan agreement, or financial derivative valuation.

• LIBOR, the London Interbank Offered Rate, is by far the most widely used
and quoted reference rate.

• The London interbank interest rate is not confined to London as discussed in

the earlier chapter (Reference chapter 1)

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 Interest Rate Risk

• Interest rate risks of the firms may arise owing to one or more of the follow?

• Debt service. The debt structure of the MNE will hold different maturities of
debt, different interest rate structures (such as fixed versus floating-rate) and
different currency denominations.

• Holdings of interest-sensitive securities, i.e. the marketable securities

portfolio of the firm which in turn represent the potential earnings or interest
inflows to the firm.

• Competitive pressures have required tightening of management of interest rates

on both the left and right sides of the firm’s balance sheet

• Exhibit 8.1 illustrates how different calculation methodologies result in different

interest payments

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 Exhibit 8.1 International Interest Rate Calculations

0.55*$10,000,000*(28/360)=$42,777.78

0.55*$10,000,000*(28/365)=$42,191.78

0.55*$10,000,000*(30/360)=$45,833.33

This example deals with the debt structure of the firm, i.e. how the interest
payment on a particular loan of $10M could vary in different markets with
differential interest rates.

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 Interest Rate Risk

 Prior to describing more about the management of the most common

interest rate pricing risks, it is important to distinguish between credit risk
and repricing risk

 Credit risk is 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

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 How to manage interest rate risk?
Options for managing interest rate risk include:
1. Refinancing : MedStat could go back to its lender and restructure and refinance
the entire agreement. This is not always possible and its often expensive.

2. Forward rate agreement (FRAs) : MedStat could lock in the future interest rate
payments with forward rate agreements (FRAs), interest rate contracts similar
to foreign exchange forward contracts.

3. Interest rate future : It has gained substantial acceptance in the corporate

sector. MedStat could lock in the future interest rate payments by taking an
interest rate futures position.

4. Interest rate swap : MedStat could enter into an additional agreement with a
bank or swap dealer in which it exchanged swapped future cash flows in such a
way that the interest rate payments on the floating rate loan would become
fixed.

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 Floating-Rate Loans
• Floating-rate loans are the single largest and most frequently
observed corporate interest rate exposure.
• Borrow $1M for three years at a floating rate, LIBOR + 1.250%, LIBOR to be
reset annually. This offers flexibility, it also assures MedStat of full funding
for the 3-year period. This eliminates credit risk.

• Reprising risk is however present, i.e. if LIBOR changes dramatically by the

second or third year, then the LIBOR rate change is passed through
completely to the borrower. The spread however remains fixed.

• LIBOR component is truly floating, the spread of 1.250% is actually a

fixed component of the interest payment, which is known with
certainty for the life of the loan.

• MedStat will not know the actual interest cost of the loan until the
loan has been completely repaid.

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 Exhibit 8.2 MedStat’s Floating-Rate Loan

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 Forward Rate Agreements

• A forward rate agreement (FRA) is an interbank-traded contract to buy or sell

interest rate payments on a notional principal.

• The buyer of an FRA obtains the right to lock in an interest rate for a desired
term that begins at a future date with maturities of 1, 3, 6, 9, or 12 months.

• EXAMPLE: Please refer to the next few slides to explain this concept
(Numercial is also part of the Tutorial Question for Chapter 8).

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 Forward Rate Agreements
Firenza Motors of Italy recently took out a 4-year €5 million loan on a floating rate basis. It is now worried, however, about rising
interest costs. Although it had initially believed interest rates in the Euro-zone would be trending downward when taking out the
loan, recent economic indicators show growing inflationary pressures. Analysts are predicting that the European Central Bank will
slow monetary growth driving interest rates up.

Firenza is now considering whether to seek some protection against a rise in euro-LIBOR, and is considering a Forward Rate
Agreement (FRA) with an insurance company. According to the agreement, Firenza would pay to the insurance company at the end
of each year the difference between its initial interest cost at LIBOR + 2.50% (6.50%) and any fall in interest cost due to a fall in
LIBOR. Conversely, the insurance company would pay to Firenza 70% of the difference between Firenza’s initial interest cost and
any increase in interest costs caused by a rise in LIBOR.

Purchase of the floating Rate Agreement will cost €100,000, paid at the time of the initial loan. What are Firenza’s annual
financing costs now if LIBOR rises and if LIBOR falls.? Firenza uses 12% as its weighted average cost of capital. Do you recommend
that Firenza purchase the FRA?

Assumptions Values
Principal borrowing need € 5,000,000
Maturity needed, in years 4.00
Current LIBOR 4.000%
Felini's bank spread 2.500%
Proportion of differential paid by FRA 70%
Cost of FRA € 100,000

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 Forward Rate Agreements
• According to the agreement, Firenza would pay to the insurance company
at the end of each year the difference between its initial interest cost at
LIBOR + 2.50% (6.50%) and any fall in interest cost due to a fall in LIBOR.

• Essentially, if the LIBOR points fell down, Firenza Motors pays for the
interest on the loan and pays money (outflow) under FRA charges will be
paid to the insurance company (i.e. the difference in the interest rate
(LIBOR+Spread) from year 0 up to the year 4)

• Conversely, the insurance company would pay to Firenza Motors 70% of

the difference between Firenza’s initial interest cost and any increase in
interest costs caused by a rise in LIBOR.

• Essentially, if the LIBOR points went up, Firenza Motors pays for the
interest on the loan and receives money (inflow) under FRA fees will be
paid by the insurance company (i.e. 70% the difference in the interest rate
(LIBOR+Spread) from year 0 up to the year 4)

• Purchase of the Floating Rate Agreement will cost €100,000, paid at the
time of the initial loan.

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 Forward Rate Agreements
If LIBOR Rises 50 Basis Pts Per Year Year 0 Year 1 Year 2 Year 3 Year 4

Expected annual change in LIBOR 0.500%

LIBOR 4.000% 4.500% 5.000% 5.500% 6.000%

Bank spread 2.500% 2.500% 2.500% 2.500% 2.500%
Interest rate 6.500% 7.000% 7.500% 8.000% 8.500%
(Given)
Funds raised, net of fees € 5,000,000
(5000,000*7%) (5000,000*7.5%) (5000,000*8%) (5000,000*8.5%)
Expected interest (interest rate x principal) -€ 350,000 -€ 375,000 -€ 400,000 -€ 425,000
(Given) ((7%-6.5%)*5000,000) ((7.5%-6.5%)*5000,000) ((8%-6.5%)*5000,000) ((8.5%-6.5%)*5000,000)
Forward Rate Agreement -€ 100,000 € 17,500 € 35,000 € 52,500 € 70,000
Repayment of principal -€ 5,000,000
Total cash flows € 4,900,000 -€ 332,500 -€ 340,000 -€ 347,500 -€ 5,355,000

All-in-cost of funds (IRR) 7.458%

NPV at 5% € 4,900,000 -€ 316,540 -€ 308,380 -€ 300,240 -€ 4,407,165

NPV at 10% € 4,900,000 -€ 302,243 -€ 280,840 -€ 260,973 -€ 3,657,465
MANUAL Excel
NPV at 5% -€ 432,325 7.602% -€ 410,297
NPV at 10% € 398,480 € 361,924

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 Forward Rate Agreements
If LIBOR Falls 50 Basis Pts Per Year Year 0 Year 1 Year 2 Year 3 Year 4
2.5%/5, where 5 is the total number of years
Expected annual change in LIBOR -0.500%

LIBOR 4.000% 3.500% 3.000% 2.500% 2.000%

Bank spread 2.500% 2.500% 2.500% 2.500% 2.500%
Interest rate 6.500% 6.000% 5.500% 5.000% 4.500%

Funds raised, net of fees € 5,000,000

(5000,000*6%) (5000,000*5.5%) (5000,000*5%) (5000,000*4.5%)
Expected interest (interest rate x principal) -€ 300,000 -€ 275,000 -€ 250,000 -€ 225,000
(Given) ((6%-6.5%)*5000,000) ((5.5%-6.5%)*5000,000) ((5%-6.5%)*5000,000) ((4.5%-6.5%)*5000,000)
Forward Rate Agreement -€ 100,000 -€ 25,000 -€ 50,000 -€ 75,000 -€ 100,000
Repayment of principal -€ 5,000,000
Total cash flows € 4,900,000 -€ 325,000 -€ 325,000 -€ 325,000 -€ 5,325,000
PV at 5% 1.000 0.952 0.907 0.864 0.823
NPV at 5% € 4,900,000 -€ 309,400 -€ 294,775 -€ 280,800 -€ 4,382,475
PV at 10% 1.000 0.909 0.826 0.751 0.683
NPV at 10% € 4,900,000 -€ 295,425 -€ 268,450 -€ 244,075 -€ 3,636,975

All-in-cost of funds (IRR) 7.092%

Excel Manual 7.234%
NPV at 5% -€ 348,520 -€ 367,450
NPV at 10% € 413,388 € 455,075

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 Forward Rate Agreements
If LIBOR Stays the same Pts Per Year Year 0 Year 1 Year 2 Year 3 Year 4
(Assume no change in interest rate)
Expected annual change in LIBOR 0.000%

LIBOR 4.000% 4.000% 4.000% 4.000% 4.000%

Bank spread 2.500% 2.500% 2.500% 2.500% 2.500%
Interest rate 6.500% 6.500% 6.500% 6.500% 6.500%
(Given)
Funds raised, net of fees € 5,000,000
(5000,000*6.5%)
Expected interest (interest rate x principal) -€ 325,000 -€ 325,000 -€ 325,000 -€ 325,000
(Given) ((6.5%-6.5%)*5000,000)
Forward Rate Agreement -€ 100,000 €0 €0 €0 €0
Repayment of principal -€ 5,000,000
Total cash flows € 4,900,000 -€ 325,000 -€ 325,000 -€ 325,000 -€ 5,325,000

All-in-cost of funds (IRR) 7.092%

NPV at 5% € 4,900,000 -€ 309,400 -€ 294,775 -€ 280,800 -€ 4,382,475

NPV at 10% € 4,900,000 -€ 295,425 -€ 268,450 -€ 244,075 -€ 3,636,975
EXCEL MANUAL
NPV at 5% -€ 348,520 7.234% -€ 367,450
NPV at 10% € 413,388 € 455,075

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 Interest Rate Swaps
• Swaps are contractual agreements to exchange or swap a
series of cash flows.
• If the agreement is for one party to swap its fixed interest rate
payment for the floating interest rate payments of another, it
is termed an interest rate swap or plain-vanilla swap.

• If the agreement is to swap currencies of debt service it is

termed a currency swap or cross-currency swap.

• A single swap may combine elements of both interest rate

swaps and currency swaps.

• Firms may enter into a swap for any reason it sees fit and
then swap a notional principal that is less than, equal to,
or even greater than the total position being managed.

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 Plain-Vanilla Swaps
• A plain vanilla interest rate swap is often done to hedge a floating rate
exposure, although it can also be done to take advantage of a declining
rate environment by moving from a fixed to a floating rate. Both legs of
the swap are denominated in the same currency, and interest payments
are netted. The notional principal does not change during the life of the
swap, and there are no embedded options.

• Example. In a plain vanilla interest rate swap, Company A and Company B

choose a maturity, principal amount, currency, fixed interest rate,
floating interest rate index, and rate reset and payment dates. On the
specified payment dates for the life of the swap, Company A pays
Company B an amount of interest calculated by applying the fixed rate
to the principal amount, and Company B pays Company A the amount
derived from applying the floating interest rate to the principal amount.
Only the netted difference between the interest payments changes hands.

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 Cross-Currency Swaps
• A cross-currency swap is an agreement between two parties to exchange
interest payments and principal on loans denominated in two different
currencies .

• In a cross currency swap, a loan's interest payments and principal in one

currency would be exchanged for an equally valued loan and interest
payments in a different currency.

• The usual motivation for a currency swap is to replace cash flows scheduled
in an undesired currency with flows in a desired currency.

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 Reference: MedStat’s Cross-Currency Swap
• Raising $10M in floating rate financing and subsequently swapping into
fixed rate payments, MedStat decides it would prefer to make its debt
service payments in British pounds.

• MedStat recently signed a sales contract with a British buyer who will be
paying pounds to MedStat over the next three years. This would mean a
natural inflow of funds for the coming three years. Thus, MedStat wishes to
match the currency of denomination of the cash flows through a cross
currency swap.

• MedStat enters into a three year pay British pounds and receive U.S. dollar
cross-currency swap. Both interest rates are fixed. MedStat will pay 1.15%
fixed British pound interest and receive 1.26% fixed U.S dollars.

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 Exhibit 8.13 MedStat’s Cross-Currency Swap

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 Thank you

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