The Spaniards coming into the West Indies had many commodities of the country which they needed, brought unto them by the inhabitants, to who when they offered them money, goodly pieces of gold coin, the Indians, taking the money, would put it into their

Step-down coupon notes are debt instruments with a high coupon in earlier payment periods and a lower coupon in later payment periods. This structure is usually motivated by a low short-term rate environment and regulatory or tax considerations. Investors seeking to front-load their interest income would be interested in such notes.

9.4 Summary and Conclusions

Multinational corporations can use creative financing to achieve various objectives, such as lowering their cost of funds, cutting taxes, and reducing political risk. This chapter focused on two such techniques—interest rate and currency swaps and interest rate forward and futures contracts.

Interest and currency swaps involve a financial transaction in which two counterparties agree to exchange streams of payments over time. In an interest rate swap, no actual principal is exchanged either initially or at maturity, but interest payment streams are exchanged according to predetermined rules and are based on an underlying notional amount. The two main types are coupon swaps (or fixed rate to floating rate) and basis swaps (from floating rate against one reference rate to floating rate with another reference rate).

Currency swap refers to a transaction in which two counterparties exchange specific amounts of two currencies at the outset and repay over time according to a predetermined rule that reflects both interest payments and amortization of principal. A cross-currency interest rate swap involves swapping fixed-rate flows in one currency to floating-rate flows in another.

Interest forward and futures contracts enable companies to manage their interest rate expense and risk. These contracts include forward forwards, forward rate agreements, and Eurodollar futures. All of them allow companies to lock in interest rates on future loans and deposits. A forward forward is a contract that fixes an interest rate today on a future loan or deposit. The contract specifies the interest rate, the principal amount of the future deposit or loan, and the start and ending dates of the future interest rate period.

A forward rate agreement is a cash-settled, over-the-counter forward contract that allows a company to fix an interest rate to be applied to a specified future interest period on a notional principal amount. Eurodollar futures, which are based on a three-month, $1 million Eurodollar deposit that pays LIBOR, act like FRAs in that they help lock in a future interest rate and are settled in cash. However, unlike FRAs, they are marked to market daily. Eurodollar futures contracts are traded on several U.S. and overseas exchanges.

Structured notes are complex debt instruments whose payments are tied to a reference index, such as LIBOR, and have one or more embedded derivative elements, such as swaps, forwards, or options. However, they do perform a valuable function. They allow corporations and financial institutions to function more efficiently by enabling them to tailor financial products to meet their individual needs.

Questions

1. What is an interest rate swap? What is the difference between a basis swap and a coupon swap?

2. What is a currency swap?

3. Comment on the following statement. “In order for one party to a swap to benefit, the other party must lose.”

4. The Swiss Central Bank bans the use of Swiss francs for Eurobond issues. Explain how currency swaps can be used to enable foreign borrowers who want to raise Swiss francs through a bond issue outside of Switzerland to get around this ban.

5. Explain how IBM can use a forward rate agreement to lock in the cost of a one-year $25 million loan to be taken out in six months. Alternatively, explain how IBM can lock in the interest rate on this loan by using Eurodollar futures contracts. What is the major difference between using the FRA and the futures contract to hedge IBM's interest rate risk?

Problems

1. Dell Computers wants to borrow pounds, and Virgin Airlines wants to borrow dollars. Because Dell is better known in the United States, it can borrow on its own dollars at 7% and pounds at 9%, whereas Virgin can on its own borrow dollars at 8% and pounds at 8.5%.

a. Suppose Dell wants to borrow £10 million for two years, Virgin wants to borrow $16 million for two years, and the current ($/£) exchange rate is $1.60. which swap transaction would accomplish this objective? Assume the counterparties would exchange principal and interest payments with no rate adjustments.

b. What savings are realized by Dell and Virgin?

c. Suppose, in fact, that Dell can borrow dollars at 7% and pounds at 9%, whereas Virgin can borrow dollars at 8.75% and pounds at 9.5%. What range of interest rates would make this swap attractive to both parties?

d. Based on the scenario in Part c, suppose Dell borrows dollars at 7% and Virgin borrows pounds at 9.5%. If the parties swap their currency proceeds, with Dell paying 8.75% to Virgin for pounds and Virgin paying 7.75% to Dell for dollars, what are the cost savings to each party?

2. In May 1988, Walt Disney Productions sold to Japanese investors a 20-year stream of projected yen royalties from Tokyo Disneyland. The present value of that stream of royalties, discounted at 6% (the return required by the Japanese investors), was ¥93 billion. Disney took the yen proceeds from the sale, converted them to dollars, and invested the dollars in bonds yielding 10%. According to Disneys chief financial officer, Gary Wilson, “In effect, we got money at a 6% discount rate, reinvested it at 10%, and hedged our royalty stream against yen fluctuations—all in one transaction.”

a. At the time of the sale, the exchange rate was ¥124 = $1. What dollar amount did Disney realize from the sale of its yen proceeds?

b. Demonstrate the equivalence between Walt Disney's transaction and a currency swap. (Hint: A diagram would help.)

c. Comment on Gary Wilson's statement. Did Disney achieve the equivalent of a free lunch through its transaction?

3. Suppose that IBM would like to borrow fixed-rate yen, whereas Korea Development Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen at 4.5% or floating-rate dollars at LIBOR + 0.25%. KDB can borrow fixed-rate yen at 4.9% or floating-rate dollars at LIBOR + 0.8%.

a. What is the range of possible cost savings that IBM can realize through an interest rate/currency swap with KDB?

b. Assuming a notional principal equivalent to $125 million and a current exchange rate of ¥105/$, what do these possible cost savings translate into in yen terms?

c. Redo Parts a and b assuming that the parties use Bank of America, which charges a fee of 8 basis points to arrange the swap.

4. At time t, 3M borrows ¥12.8 billion at an interest rate of 1.2%, paid semiannually, for a period of two years. It then enters into a two-year yen/dollar swap with Bankers Trust (BT) on a notional principal amount of $100 million (¥12.8 billion at the current spot rate). Every six months, 3M pays BT U.S. dollar LIBOR6, while BT makes payments to 3M of 1.3% annually in yen. At maturity, BT and 3M reverse the notional principals. Assume that LIBOR6 (annualized) and the ¥/$ exchange rate evolve as follows:

Time (months)

LIBOR6

¥/$ (spot)

Net $ receipt (+)/payment (—)

t

5.7%

128

t + 6

5.4%

132

t + 12

5.3%

137

t + 18

5.9%

131

t + 24

5.8%

123

a. Calculate the net dollar amount that 3M pays to BT (” − “) or receives from BT (” + “) in each six-month period.

b. What is the all-in dollar cost of 3M's loan?

c. Suppose 3M decides at t + 18 to use a six-month forward contract to hedge the t + 24 receipt of yen from BT. Six-month interest rates (annualized) at t + 18 are 5.9% in dollars and 2.1% in yen. With this hedge in place, what fixed dollar amount would 3M have paid (received) at time t + 24? How does this amount compare to the t + 24 net payment computed in Part a?

d. Does it make sense for 3M to hedge its receipt of yen from BT? Explain.

5. Suppose LIBOR3 is 7.93% and LIBOR6 is 8.11%. What is the forward forward rate for a LIBOR3 deposit to be placed in three months?

6. Suppose that Skandinaviska Ensilden Banken (SEB), the Swedish bank, funds itself with three-month Eurodollar time deposits at LIBOR. Assume that Alfa Laval comes to SEB seeking a one-year, fixed-rate loan of $10 million, with interest to be paid quarterly. At the time of the loan disbursement, SEB raises three-month funds at 5.75% but has to roll over this funding in three successive quarters. If it does not lock in a funding rate and interest rates rise, the loan could prove to be unprofitable. The three quarterly refunding dates fall shortly before the next three Eurodollar futures-contract expirations in March, June, and September.

a. At the time the loan is made, the price of each contract is 94.12, 93.95, and 93.80. Show how SEB can use Eurodollar futures contracts to lock in its cost of funds for the year. What is SEB's hedged cost of funds for the year?

b. Suppose that the settlement prices of the March, June, and September contracts are, respectively, 92.98, 92.80, and 92.66. What would have been SEB's unhedged cost of funding the loan to Alfa Laval?

Web Resources

www.bis.org/publ/index.htm Web page of the Bank for International Settlements. Contains downloadable publications such as the BIS Annual Report, statistics on derivatives, external debt, foreign exchange market activity, and so on.

www.isda.org Web site of the International Swaps and Derivatives Association (ISDA). Contains information and data on swaps and other derivatives.

Web Exercises

1. What were the volumes of interest and currency swaps during the past year? How do these figures compare to those from the previous year?

2. What risk factors associated with swaps does the ISDA discuss on its Web site?

Bibliography

Smith, Clifford W, Jr., Charles W Smithson, and Lee M. Wakeman. “The Evolving Market for Swaps.” Midland Corporate Finance Journal, Winter 1986, pp. 20-32.

(Shapiro 328)

Shapiro. Multinational Financial Management, 9th Edition. John Wiley & Sons. .