Kế toán doanh nghiệp - Chapter 21: Interest rate swaps, currency swaps and credit default swaps

Chapter 21Interest rate swaps, currency swaps and credit default swapsWebsites:www.bis.orgwww.afma.com.auLearning objectivesDescribe the nature of a swap and explain the structure and operation of vanilla and basis interest rate swapsUnderstand the importance of the interest rate swap marketExamine the structure of a cross-currency swap and how they can be arrangedExplain the rationale for the cross-currency swap marketsIntroduce the concepts and parties to credit default swapsConsider the risks for an intermediary, or a counterparty, to a swapChapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.1 Interest rate swapsNotional value of swap market transactions in 2010Australian marketInterest rate swaps AUD 5 923 billionCurrency swaps AUD 23 963 billionCredit derivatives AUD 247 billionInternational marketsInterest rate swaps USD 347 508 billionCurrency swaps USD 16 347 billionCredit default swaps USD 30 261 billionNote: the figures are not comparable. The Australian market figures are annual turnover while the international figures are notional value at a point in time.(cont.)21.1 Interest rate swaps (cont.)Swaps may be used to hedge interest risk and exchange rate risk, and also enable investors and borrowers to obtain a lower cost of funds or a higher yieldOrganised between borrowing partiesThe two parties swap their interest payment obligationsNo transfer of the principal amountBoth parties benefit from the swap(cont.)21.1 Interest rate swaps (cont.)Example: Table 21.1 outlines the current cost of funds for two borrowersFirm A has a credit advantage in both markets(cont.)21.1 Interest rate swaps (cont.)StrategyFirm A borrows in a fixed market, where it has comparative advantage (i.e. 12%)Firm B borrows in another market (i.e. floating) at BBSW + 1.70%.One possible direct swap arrangement negotiable between firms A and BB pays A a fixed rate of 13.60%A pays B a floating rate of BBSW + 1.70%Figure 21.1 illustrates the flow of funds and benefits of this interest rate swap(cont.)21.1 Interest rate swaps (cont.)(cont.)21.1 Interest rate swaps (cont.)The majority of swaps require the involvement of an intermediary, e.g. merchant bank, that often seeks an offsetting ‘matched swap’ It enters into opposite swap transactions to offset its net swap exposure, making a profit through a spread between the ratesFigures 21.3 and 21.4 in the textbook illustrate intermediated interest rate swaps(cont.)21.1 Interest rate swaps (cont.)(cont.)21.1 Interest rate swaps (cont.)Chapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.2 Rationale for the existence of interest rate swapsReasons why the use of interest swaps has continued to growLowering the cost of funds (comparative advantage)Access gained to otherwise inaccessible debt marketsHedge interest rate risk exposuresProfit margins locked in on economic transactions(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Lowering the net cost of funds (comparative advantage)For a comparative advantage to exist, the advantage in the fixed market must be different from that in the floating market (i.e. different risk premium)Why does this occur?Segmentation between floating and fixed debt marketsSome types of institutions lend more heavily in floating markets (commercial banks) while others lend more heavily in fixed markets (life insurance offices, superannuation funds and unit trust funds)(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Lowering the net cost of funds (comparative advantage) (cont.)Despite exploitation of arbitrage opportunities that has reduced the possibility of profitable swap arbitrage arrangements, the interest rate swap market continues to grow for other reasonsTable 21.2 indicates how interest rates in the two markets might adjust to remove the possibility of a profitable swap based on comparable advantage(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Gaining access to otherwise inaccessible debt marketsBanks generally prefer lending at floating rates because it allows them to maximise their spread on loans when interest rates are changingDespite this, banks may provide limited funding to a client at fixed rates with the balance lent at floating ratesCorporate borrowers able to issue fixed interest bonds must have a good credit ratingOther borrowers obtain floating-rate funds from banks and use a swap to obtain a net fixed rate cost of funds(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Hedging existing interest rate exposuresExample: a firm has an existing floating-rate loan and is concerned that floating rates will riseStrategy: the firm is able to synthesise (create) a fixed-cost loan by:paying a fixed rate to the swap counterpartyreceiving a floating payment from the counterpartyEffect: if floating rate rises, firm’s payments to floating-rate lenders increases, but are matched by increase in receipts from swap counterparty, and payment to counterparty remains fixed(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Hedging existing interest rate exposures (cont.)Example: a firm has an existing fixed-rate liability and is concerned floating rates will fallStrategy: the firm is able to synthesise (create) a floating-rate cost of funds by:paying a floating rate to the swap counterpartyreceiving a fixed-rate payment from the counterpartyEffect: fixed-rate payment received from counterparty is used to pay fixed-rate lenders, leaving the firm to make only a net floating-rate payment(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Locking in profit margins on economic transactionsA manufacturer or provider of fixed-price goods or services is exposed to any movements in variable costs (such as floating-rate funds) and has an incentive to enter into a swapLocking in a net fixed-costs fund locks in a fixed-profit margin for the firm(cont.)21.2 Rationale for the existence of interest rate swaps (cont.)Swaps in practiceIn reality more complex swap arrangements exist than the previous examplesSwaps are likely to be more dynamicExisting swaps will be monitored and actively managedSwaps may be reversed when current interest rates change, or when interest rate expectations alterChapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps 21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.3 Currency swapsTwo parties exchange debt denominated in different currenciesInterest payments are exchangedPrincipals are exchanged at the beginning of an agreement and then re-exchanged at the conclusion of the agreement, usually at the same exchange rate(cont.)21.3 Currency swaps (cont.)Example:Table 21.3 indicates there is a cost-of-funds benefit from the currency swap agreement of 0.50% per annum(cont.)21.3 Currency swaps (cont.)Example (cont.)Assuming X prefers USD and Y prefers AUD, a fixed-to-fixed currency swap strategy could be the following:Commencement of swap: currency swapX borrows AUD20 million and transmits it to YY borrows USD18.4 million and transmits it to XExchange rate is AUD/USD0.9200X and Y agree on the interest payment swap rates(cont.)21.3 Currency swaps (cont.)(cont.)21.3 Currency swaps (cont.)Example (cont.)Interest paymentsX pays 11.50% in USD to YY pays 9.75% in AUD to XBoth secure a cost of funds at 0.25% lower than if they had borrowed their preferred currency in their own right(cont.)21.3 Currency swaps (cont.)(cont.)21.3 Currency swaps (cont.)Example (cont.)Maturity of swap: currency re-exchangeAt conclusion of the swap agreement, principal amounts are re-exchanged along with the final interest paymentsX transmits USD18.4 million to YY transmits AUD20 million to XAt original exchange rate of AUD/USD0.9200EffectWhile FX risk is eliminated, both X and Y will need to obtain internally or purchase the relevant interest and principal amounts at the current exchange rate when dueA notional FX gain or loss can still be made(cont.)21.3 Currency swaps (cont.)Chapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.4 Rationale for the existence of currency swapsCurrency swaps exist for the same reasons interest rate swaps are popular:Lowering the net cost of fundsGaining access to otherwise inaccessible debt marketsHedging interest rate (FX) risk exposuresLocking in profit margins on economic transactions(cont.)21.4 Rationale for the existence of currency swapsLowering the net cost of fundsBorrowers may obtain better terms by borrowing in different markets, including those denominated in foreign currencies; thus creating a need for currency swapsHedging FX riskTwo companies can follow their comparative advantage in the debt markets and enter a currency swap(cont.)21.4 Rationale for the existence of currency swaps (cont.)Chapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.5 Credit default swapsCredit riskPossibility that an obligor (borrower) will not meet a future financial commitment (interest or principal) to a lenderCredit default swap (CDS)An agreement transferring credit risk from the protection buyer to the protection seller on the payment of a premiumPremium paid by the protection buyer is typically a number of basis points relative to the credit protection amount(cont.)21.5 Credit default swaps (cont.)Credit default swap (CDS) (cont.)CDS protection sellerInstitution that writes a CDS, accepting the credit risk of a reference entity and undertaking to compensate the protection buyer if a specified credit default event occursTypically, insurance companies, banks, investment managers and hedge funds that have identified a capacity to accept higher levels of credit risk exposure in their balance sheetsReference entityAn obligor (borrower) with a debt or loan obligation to the CDS protection buyer, e.g. a corporation or government(cont.)21.5 Credit default swaps (cont.)Credit default swap (CDS) (cont.)CDS protection buyerLender or investor buying a CDS to transfer risk associated with a reference entityTypically, banks, portfolio managers and multinational corporations that have identified a need to manage a credit risk exposure in their balance sheetsThe CDS specifies a credit default eventE.g. bankruptcy, obligation acceleration, obligation default, cash payment failure, repudiation or moratorium of debt by a nation state(cont.)21.5 Credit default swaps (cont.)Credit default swap (CDS) (cont.)In the event of credit default by the reference entity the most common forms of settlement are:Physical settlementProtection buyer delivers the agreed notional value of the debt of the reference entity to the protection seller and receives payment of that amount by the protection sellerCash settlementProtection seller pays a net cash amount to the protection buyer, usually based on the difference between the face value and the current market value of the underlying reference debt instruments(cont.)21.5 Credit default swaps (cont.)(cont.)21.5 Credit default swaps (cont.)CDSs attracted a lot of attention during the GFCIn particular, many of the ‘toxic’ mortgage securities were ‘insured’ by CDSsAs the mortgage bond market and mortgage derivatives markets suffered large losses, the CDSs rose in valueThis market movement exposed issuers of CDSs to significant and rapidly growing liabilitiesAmerican International Group (AIG) was most dramatically impacted. Chapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.6 Credit and settlements risk associated with swapsCredit riskMost swaps are through an intermediaryIntermediary is at risk if one of the two counterparties defaultsIntermediary is exposed to interest rate risk (i.e. uncertainty associated with fixed and floating markets)Exposure of intermediary limited to the difference between what a firm would have paid to, and received from, the intermediaryAlso occurs with currency swaps where a party defaults on the payment of interest or principal(cont.)21.6 Credit and settlements risk associated with swaps (cont.)Settlements riskWith currency swaps settlements risk occurs if one party settles an obligation within its time zone and the other party later defaults within a different time zoneSignificant time zone differentials can create this timing differenceChapter organisation21.1 Interest rate swaps21.2 Rationale for the existence of interest rate swaps21.3 Currency swaps21.4 Rationale for the existence of currency swaps21.5 Credit default swaps21.6 Credit and settlements risks associated with swaps21.7 Summary21.7 SummarySwaps facilitate the exchange of specified cash flowsInterest rate swaps are used to: reduce the cost of borrowingmanage existing interest rate exposuresCurrency swaps are used when an interest rate swap involves borrowing in different currenciesAllow the management of interest rate and FX risk exposureCurrency swaps differ from interest rate swaps in that the principal amounts raised by the two borrowers are swapped at commencement and re-exchanged at the end of the agreement