Special Topics 7:

Multinational
Finance

Derivatives: Swaps

Professor Anthony R Sanichara

Andrews University

Brigham & Houston, Fundamentals of Financial Management, Sixteenth Edition. © 2022 Cengage. All Rights Reserved. May not be scanned,
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Purpose

• There are many Derivative and Swap instruments that are designed to
help MNCs manage interest rate risk, exchange rate risk, credit risk, and
combinations of those risks.

• The Bureau for International Settlements (BIS) based in Basel, Switzerland

estimates that there are over $350 trillion of interest rate swaps and $26
trillion of currency swaps outstanding (as of 2018).

• There is over $8.3 trillion of Credit Default Swaps (CDS) outstanding.

• Chapter 8
Interest Rate Swaps
What is an Interest Rate Swap?
• An interest rate swap is an agreement between two parties to exchange
the interest payments of the same maturity on a notional principal.
• The notional principal or notional amount is simply a reference amount
against which the interest rate is calculated. No principal amount changes
hands.
• In a coupon swap one party pays a fixed interest rate in exchange for the
other party to pay a floating interest rate. The fixed rate is calculated as a
percentage of the notional principal and does not change over time. The
floating rate is an interest rate that is periodically reset based on a spread
over a reference rate that changes over time (e.g.: LIBOR, Fed Funds Rate).

• Chapter 8
London Inter-Bank Offered Rate (LIBOR)
• The LIBOR is the most common reference rate.
• It is an average interest rate set by global banks in London and is
calculated once a day at 11AM London Time.
• The Intercontinental Exchange (ICE) based in New York, currently
administers the survey. It took over from the British Bankers Association
(BBA) in 2014 following allegations of rigging.
• The LIBOR is actually 35 different rates (7 maturities x 5 currencies).
• The maturities available are Overnight, 1 week, and 1, 2, 3, 6, and 12
months.
• The currencies available are CHF, EUR, GBP, JPY, and USD.
• LIBOR is currently being phased out by most countries but there is
currently no clear alternative leading the way.

• Chapter 8
Interest Rate Swap Transaction
• United Airlines is rated BBB and would like also like to borrow $100 million
for 5 years but it would prefer to have a fixed rate.
• Microsoft which is rated AAA would like to borrow $100 million for 5 years
at a floating rate.
• The rates that each company can borrow at are:
Borrower Fixed Rate Available Floating Rate Available

United Airlines (BBB) 8.5% 6-mth LIBOR + 0.5%

Microsoft (AAA) 7.0% 6-mth LIBOR

Difference 1.5% 0.5%

• Microsoft can borrow at lower fixed and floating rates than United.
• But United has a comparative advantage in borrowing at the floating rate.

• Chapter 8
Interest Rate Swap Transaction
• United and Microsoft can take advantage of this opportunity by each
borrowing at the rate where they have a comparative advantage and
swapping the cash flows to get what they want.
• United borrows at the floating rate and Microsoft at the fixed rate.
• They then agree to swap the cash flows. But for this to be interesting it
needs to be beneficial to both parties. So let’s say that Microsoft agrees to
pay United the 6-mth LIBOR and United agrees to pay Microsoft 7.35%.
Borrower United Airlines (BBB) Microsoft (AAA)
Pays bondholders 6-mth LIBOR + 0.5% 7%

Receives from other party -6-mth LIBOR -7.35%

(negative because it reduces costs)
Pays to other party 7.35% 6-mth LIBOR

Difference LIBOR+0.5%-LIBOR+7.35%=7.85% 7%-7.35%+LIBOR=LIBOR-0.35%

• Chapter 8
Interest Rate Swap Transaction
• United now has a fixed rate payment of 7.85% and it is less than the fixed rate
bond of 8.5% it could get on its own (a savings of 65 basis points).
• Microsoft now has a floating rate payment of LIBOR-0.35% and it is less costly than
the floating rate bond of LIBOR (a savings of 35 basis points).
• Remember there was a 1.5% differential between United and Microsoft in the
fixed rate and a 0.5% differential in the floating rate. That is a 1% or 100 basis
point gap.
• Both United and Microsoft were able to take advantage of their comparative
advantage and used the interest rate swap to exploit the 100 basis point gap.
• In reality, an intermediary would help orchestrate the transaction for a fee. Let’s
say 10 basis points. Leaving Microsoft and United to share the remaining 90 basis
point gap.

• Chapter 8
Currency Swaps
Currency Swap Transaction
• A currency swap is an exchange between two parties of interest payments
that are denominated in different currencies.
• In a fixed-for-fixed currency swap the interest payments that the two
parties exchange are both fixed rates. The main purpose a fixed-for-fixed
currency swap is to manage exchange rate risk.
• In a fixed-for-floating currency swap one counterparty exchanges a fixed
rate payment denominated in one currency for a floating rate
denominated in another currency. A fixed-for-floating currency swap can
help manage both interest rate and exchange rate risk.
• In the case of currency swaps there is an exchange of principal amounts at
maturity but there is no exchange of principal in an interest rate swap.

• Chapter 8
Fixed-for-Fixed Currency Swap
• Suppose the US-based chemical company
DowDupont is looking to borrow $200
million in euros and the France-based tire
maker Michelin is looking to borrow $200
million. Both would like a fixed rate and a
maturity of 10 years.
• DowDupont can issue $ debt at 7.5% and €
debt at 8.25%.
• Michelin can issue $ debt at 7.7% and €
debt at 8.1%.
• The spot rate is €1.1 buys $1.
• Michelin has a comparative advantage at
borrowing in euros and DowDupont in
dollars.
• They can then swap the proceeds and the
cash flows.
• Both parties benefit from a lower cost of
borrowing

• Chapter 8
Fixed-for-Floating Currency Swap
• Suppose that DowDupon would prefer a
floating rate debt but Michelin would still
like a fixed rate.
Borrower Floating Rate in euros Fixed Rate in
dollars
Michelin LIBOR+0.125% 7.7%

DowDupont LIBOR+0.35% 7.5%

Difference -0.225% 0.2%

• In this case, the optimal strategy is for

both companies to borrow in their
respective currencies and swap the debt.
• Michelin will still have a 7.5% dollar fixed
debt and DowDupont will now have a
floating rate LIBOR+0.125% euro debt.

• Chapter 8
Interest Rate Forward
and Futures
Forward Forward Agreement (FFA)
• 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 loan or deposit and the start and ending dates of the future interest rate
period.
• A forward forward agreement can be “homemade.”
• Suppose a company wants to lock the rate for a deposit of €1,000,000 in 3
months for 6 months. Suppose it can borrow and lend at LIBOR. The LIBOR3 is 4%
and the LIBOR9 is 5%.
• It can borrow €1,000,000/(1+4%/4)= €990,099 and lend that amount at LIBOR9.
• In 3 months it will pay back the loan for €1,000,000.
• In 9 months it will receive €990,099 x (1+5% x 3/4)= €1,027,228.
• In equilibrium the actual forward rate for LIBOR6 in three months will equal the
“homemade” forward forward.

• Chapter 8
Forward Rate Agreement (FRA)

• Forward forward agreements have been replaced by forward rate agreements which are
traded over the counter (OTC).
• In 2018, the notional amount of FRAs was $84 trillion.
• In an FRA there is a cash settlement where one party pays the other the difference
between the actual interest expense and the negotiated forward rate expense.
• The formula to calculate the interest payment on a LIBOR-based FRA is:

days
LIBOR − forward rate ×
360
Interest payment = notional principal ×
days
1 + LIBOR ×
360

• Chapter 8
Unilever uses an FRA to fix the interest rate on a future loan
• Unilever needs to borrow $50 million in two months for a 6-month
period.
• To lock the rate, Unilever buys a “2 x 6” FRA from BofA on LIBOR at 6.5%
• In two months if LIBOR6 exceeds 6.5%, BofA will pay Unilever the
difference in interest expense. If LIBOR6 is less than 6.5% it is Unilever
that will pay the difference in interest expense to BofA.
• In two months if LIBOR6 is 7.2%, Unilever will receive:
1
0.072 − 0.065 ×
2
Interest payment = $50,000,000 × = $170,730
1
1 + 0.072 ×
2

• Chapter 8
Eurodollar Futures

• A Eurodollar future is a cash-settled futures contract on a 3 month, $1 million

Eurodollar deposit that pays LIBOR.
• Contracts are traded on the CME (Chicago), ICE (NYC, London, and
Singapore), and the SGX (Singapore).
• The contracts settle in March, June, September, and December.
• Eurodollars are U.S. dollars on deposit outside the United States.
• Eurodollar futures are similar to FRAs but unlike FRAs they are marked-to-
market daily. That is, gains and losses are settled each day.
• The price of Eurodollar future is quoted as an index number equal to 100
minus the annualized forward LIBOR3.
• Example: a price of 91.68 means that the contracted LIBOR3 is 100-
91.68=8.32%

• Chapter 8
Eurodollar Futures

• If the price of the Eurodollar futures contract is 91.68 then the initial value of
the contract is:
100 − 91.62 90
Initial value = $1,000,000 × 1 − = $979,200
100 360

• At maturity, the cash settlement price is determined by subtracting LIBOR3

on that date from 100. If LIBOR3 at settlement is 7.54% then the contract
price is 100-7.54=92.46.
100 − 92.46 90
Settlement value = $1,000,000 × 1 − = $981,150
100 360

• Chapter 8
Structured Notes
Structure Notes

• A structured note is an interest bearing security whose interest payments

are determined by reference to a formula and adjusted on reset dates.
• The formula is usually tied to one or more specific references such as a
variable interest rate (LIBOR, Fed Funds Rate, …), exchange rates
(EUR/USD, …) or commodity prices (Price of Gold, Oil, …).
• Can include one or more derivative elements such as swaps, forwards,
options, …
• For example, a Floating Rate Note (FRN) which we have seen previously is
a structured note (e.g. LIBOR+Spread).

• Chapter 8
Inverse Floaters

• An inverse floater is a floating rate debt instrument where the interest rate moves
inversely with market interest rates.
• Inverse floaters have received negative press as they were behind the Orange
County, California municipal default (at the time the largest in history).
• Generally, the coupon rate is set at nr-(n-1) x Reference Rate. Where r is the rate
on a comparable fixed rate bond and n is a multiplier.
• Example, GE has a fixed rate bond with a coupon rate of 2%. It issues a floater
based on LIBOR6 with a multiplier of 3 which resets every 6 months.
• The floating rate bond will have coupons equal to 3x2%-2xLIBOR.
• GE is long 3 fixed rate bonds of 2% and short 2 bonds that pay LIBOR.
• Inverse floaters usually have caps and floors to prevent the coupon from being
negative.

• Chapter 8
Callable Step-Up Note

• A callable step-up note is a callable debt (it can be bought back by

the issuer at a scheduled call price) which pays a fixed or floating rate
that “steps-up” over the life of the note following a pre-determined
schedule.
• Issuers of callable step-up notes usually have poor credit quality.
• If the issuer’s credit quality remains the same or improves, then the
higher coupon payments will force the issuer to call the note and
refinance.
• If the issuer’s credit quality deteriorates then investors get
compensated for the higher credit risk.

• Chapter 8
Step-Down Coupon Note

• A step-down coupon note is a fixed rate debt instrument which has a

coupon rate which decreases as the bond approaches maturity.
• These bonds are motivated by:
1. A low short-term rate environment because they have a lower
sensitivity to interest rate changes (lower duration).
2. Tax considerations (front loading the interest expense increases the
present value of the tax shield).
3. Anticipated declines in operating profits.

• Chapter 8
Credit Default Swaps
Credit Default Swaps (CDS)

• Credit Default Swaps (CDS) help investors manage their credit risk exposures.
• As of 2018, CDS had $8.3 trillion worth of notional outstanding.
• Similar to an insurance product: an investor can buy a CDS to protect for a
certain number of years against the event that a bond defaults by paying a
“premium.”
• CDS are available on bonds issued by corporations and by sovereign
governments (both are called reference entities).
• MNCs can use sovereign CDS to mitigate political risk in their international
investments.
• Single Name CDS protect against a specific issuer (IBM, Brazil, …)
• CDS Indexes are bundles of CDSs on specific issuers categorized by credit
grade and/or region (High Yield, North America, …)

• Chapter 8
Single Name CDS

• Protection on $10 million Government of Colombia bonds for 5 years.

• The spread (premium) is 110 basis points.
• The buyer of the CDS will pay:
1.1% x 10 million=$110,000/year
for 5 years if no default occurs.

• If a default occurs within the 5-year period, the buyer pays the last prorated premium and receives from the
seller $10,000,000 minus any recovery on the bonds (usually 40% for corporates and 25% for Sovereigns)
• The spread the buyer pays is locked for a given contract. But new contracts will have a spread that reflects new
information (Colombia faces a COVID-19 crisis or Colombia discovers a major oil field).
• If the credit quality of Colombia deteriorates, the buyer can close out her position by selling protection for a
higher premium (earning the difference).

• Chapter 8
Single Name Credit Default Swaps

• CDS can be used to protect against

country risk.
• For instance, Ford Motors has a large
presence in Turkey producing over
300,000 cars (including the Ford Escort
for the European market).
• Suppose Ford is worried about political
instability in Turkey.
• It can buy CDS on the Government of
Turkey Bonds.
• The CDS spreads are likely to increase as
political instability increases.

• Chapter 8
CDS Indexes

• CDS Indexes are baskets of single name CDS.

• CDS Indexes are standardized products that offer more liquidity than single
name CDS.
• Two families of indexes: the iTraXX and the CDX indexes (both owned by
MarkIt).
• The buyer of the CDS index pays the average spread on the individual CDS
which is fixed at inception. If average spreads increase the value of owning
the CDS index increases and it can be sold at a profit.
• If the index is composed of N single name CDS and one of the reference
entities default, then the buyer receives a payment of 1/N x Notional
Amount and the CDS Index will trade with N-1 reference entities.

• Chapter 8
CDS Indexes
Western
CDX North American Europe
Investment Grade CEEMEA
High Volatility
CEEMEA ex-
CDX North American Regions
EU
High Yield

iTraXX SovX Family

Asia Pacific
CDX Family

CDX North American

High Yield High Beta Latin America

CDX Emerging G7
Markets Blocs
BRIC
CDX Emerging Global Liquid
Credit
Markets Diversified Investment
Quality
Grade

• Chapter 8