Trident Corporation: Swapping to Fixed Rates Maria Gonzalez (Trident’s cfo) is concerned about the floating rate loan


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Trident Corporation: Swapping to Fixed Rates

  • Maria Gonzalez (Trident’s CFO) is concerned about the floating rate loan

    • Maria thinks that rates will rise over the life of the loan and wants to protect Trident from an increased interest payment
    • Maria believes that an interest rate swap to pay fixed/receive floating would be Trident’s best alternative
    • Maria contacts the bank and receives a quote of 5.75% against LIBOR; this means that Trident will receive LIBOR and pay out 5.75% for the three years


Trident Corporation: Swapping to Fixed Rates

  • The swap does not replace the original loan, Trident must still make its payments at the original rates; the swap only supplements the loan payments

  • Trident’s 1.50% fixed rate above LIBOR must still be paid along with the 5.75% as per the swap agreement; however, Trident now receives LIBOR thus offsetting the floating rate risk in the original loan

  • Trident’s total payment will therefore be 7.25% (5.75% + 1.50%)



Trident Corporation: Swapping to Fixed Rates



Trident Corp: Swapping Dollars into Swiss francs

  • After raising the $10 million in floating rate financing and swapping into fixed rate payments, Trident decides it would prefer to make its debt-service payments in Swiss francs

    • Trident signed a 3-year contract with a Swiss buyer, thus providing a stream of cash flows in Swiss francs
  • Trident would now enter into a three-year pay Swiss francs and receive US dollars currency swap

    • Both interest rates are fixed
    • Trident will pay 2.01% (ask rate) fixed Sfr interest and receive 5.56% (bid rate) fixed US dollars




Trident Corp: Swapping Dollars into Swiss francs

  • The spot rate in effect on the date of the agreement establishes what the notional principal is in the target currency

    • In this case, Trident is swapping into francs, at Sfr1.50/$.
    • This is a notional amount of Sfr15,000,000. Thus Trident is committing to payments of Sfr301,500 (2.01%  Sfr15,000,000 = Sfr301,500)
    • Unlike an interest rate swap, the notional amounts are part of the swap agreement


Trident Corp: Swapping Dollars into Swiss francs



Trident Corporation: Unwinding Swaps

  • As with the original loan agreement, a swap can be entered or unwound if viewpoints change or other developments occur

  • Assume that the three-year contract with the Swiss buyer terminates after one year, Trident no longer needs the currency swap

  • Unwinding a currency swap requires the discounting of the remaining cash flows under the swap agreement at current interest rates then converting the target currency back to the home currency



Trident Corporation: Unwinding Swaps

  • If Trident has two payments of Sfr301,500 and Sfr15,301,500 remaining (interest plus principal in year three) and the 2 year fixed rate for francs is now 2.00%, the PV of Trident’s commitment is francs is



Trident Corporation: Unwinding Swaps

  • At the same time, the PV of the remaining cash flows on the dollar-side of the swap is determined using the current 2 year fixed dollar rate which is now 5.50%



Trident Corporation: Unwinding Swaps

  • Trident’s currency swap, if unwound now, would yield a PV of net inflows of $10,011,078 and a PV of net outflows of Sfr15,002,912. If the current spot rate is Sfr1.4650/$ the net settlement of the swap is



Counterparty Risk

  • Counterparty Risk is the potential exposure any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations

  • A firm entering into a swap agreement retains the ultimate responsibility for its debt-service

  • In the event that a swap counterpart defaults, the payments would cease and the losses associated with the failed swap would be mitigated

  • The real exposure in a swap is not the total notional principal but the mark-to-market value of the differentials



A Three-way Cross Currency Swap

  • Sometimes firms enter into loan agreements with a swap already in mind, thus creating a debt issuance coupled with a swap from its inception

    • Example: the Finnish Export Credit agency (FEC), the Province of Ontario, Canada and the Inter-American Development Bank (IADB) all possessed access to ready sources capital but wished debt service in another market
    • FEC had not raised capital in Canadian dollar Euromarkets and an issuance would be well received; however the FEC had a need for increased debt-service in US dollars, not Canadian dollars


A Three-way Cross Currency Swap

    • Province of Ontario needed Canadian dollars but due to size of provincial borrowings knew that issues would push up its cost of funds; there was however an attractive market in US dollars
    • IADB had a need for additional US dollar denominated debt-service; however it already raised most of its debt in the US markets but was a welcome newcomer in the Canadian dollar market
  • Each borrower determined its initial debt amounts and maturities expressly with the needs of the swap



A Three-way Cross Currency Swap



Summary of Learning Objectives

  • The single largest interest rate risk of the non-financial firm is debt-service. The debt structure of an MNE will possess differing maturities of debt, different interest rates and different currency denominations

  • The increasing volatility of world interest rates, combined with increasing use of short-term and variable-rate notes has led many firms to actively manage their interest rate risk



Summary of Learning Objectives

  • The primary sources of interest rate risk to an MNE are short-term borrowing and investing and long-term borrowing

  • The techniques and instruments used in interest rate risk management resemble those used in currency risk management: the old method of lending and borrowing

  • The primary instruments include forward rate agreements (FRAs), interest rate futures, forward swaps and interest rate swaps



Summary of Learning Objectives

  • The interest rate and currency swap markets allow firms that have limited access to specific currencies and interest rate structures to gain access at relatively low costs

  • A cross currency interest rate swap allows a firm to alter both the currency of denomination of the cash flows but also to alter the fixed-to-floating or floating-to-fixed interest rate structure



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