Eiteman/Stonehill/MoffettMultinationalBusinessFinance,SixteenthEdition

Chapter8:InterestRateRiskandSwaps

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Chapter8

InterestRateRiskandSwaps

8.1 ReferenceRates.Whatisaninterest“referencerate”andhowisitusedtosetratesforindividualborrowers?

Areferencerate—forexample,U.S.dollarLIBOR—istherateofinterestusedinastandardizedquotation,loanagreement,orfinancialderivativevaluation.LIBOR,theLondonInterbankOfferedRate,isbyfarthemostwidelyusedandquoted.

8.2 MyWordIsMyLIBOR.WhyhasLIBORplayedsuchacentralroleininternationalbusinessandfinancialcontracts?Whyhasthisbeenquestionedinrecentdebatesoveritsvaluereported?

NosingleinterestrateismorefundamentaltotheoperationoftheglobalfinancialmarketsthantheLondonInterbankOfferedRate(LIBOR).Butbeginningasearlyas2007,anumberofparticipantsintheinterbankmarketonbothsidesoftheAtlanticsuspectedthattherewastroublewithLIBOR.Thethreemonthandsixmonthmaturitiesarethemostsignificantmaturitiesduetotheirwidespreaduseinvariousloanandderivativeagreements,withthedollarandtheeurobeingthemostwidelyusedcurrencies.

TheissuesrelatedtoLIBORhavebeenincreasinglycomplicatedinrecentyears—beginningwiththeoriginoftheratessubmittedbybanks.First,ratesarebasedon“estimatedborrowingrates”toavoidreportingonlyactualtransactions,asmanybanksmaynotconductactualtransactionsinallmaturitiesandcurrencieseachday.Asaresult,theoriginoftheratesubmittedbyeachbankbecomes,tosomedegree,discretionary.

Secondly,banks—specificallymoneymarketandderivativetraderswithinthebanks—haveanumberofintereststhatmaybeimpactedbyborrowingcostsreportedbythebankthatday.OnesuchexamplecanbefoundintheconcernsofbanksintheinterbankmarketinSeptember2008,whenthecreditcrisiswasinfullbloom.Abankreportingthatotherbanksweredemandingitpayahigherratethatdaywould,ineffect,beselfreportingthemarket’sassessmentthatitwasincreasinglyrisky.Inthewordsofoneanalyst,akin“tohangingasignaroundone’sneckthatIamcarryingacontagiousdisease.”MarketanalystsarenowestimatingthatmanyofthebanksintheLIBORpanelwerereportingborrowingrateswhichwereanywherefrom30to40basispointslowerthanactualratesthroughoutthefinancialcrisis.

8.3 CreditRiskPremium.Whatisacreditriskpremium?

Thecostofdebtforanyindividualborrowerwillthereforepossesstwocomponents,thebaseratesuchasLIBORortherisk-freerateofinterest(kUS$),plusacreditriskpremium(RPM$Rating)reflectingtheassessedcreditqualityoftheindividualborrower.ForanindividualborrowerintheUnitedStates,thecostofdebt(kDebt$)wouldbe:

kDebt$=kUS$+RPM$Rating

Thecreditriskpremiumrepresentsthecreditriskoftheindividualborrower.Increditmarketsthisassignmentistypicallybasedontheborrower’screditratingasdesignatedbyoneofthemajorcreditratingagencies,Moody’s,Standard&Poors,andFitch.AnoverviewofthosecreditratingsispresentedinExhibit8.4.Althougheachagencyutilizesdifferentmethodologies,allincludetheindustryinwhichthefirmoperates,itscurrentlevelofindebtedness,itspast,present,andprospectiveoperatingperformance,amongamultitudeofotherfactors.

8.4 CreditandRepricingRisk.Fromthepointofviewofaborrowingcorporation,whatarecreditandrepricingrisks?Explainstepsacompanymighttaketominimizeboth.

Foracorporateborrower,itisespeciallyimportanttodistinguishbetweencreditriskandrepricingrisk.Creditrisk,sometimestermedrolloverrisk,isthepossibilitythataborrower’screditworthinessatthetimeofrenewingacredit—itscreditrating—isreclassifiedbythelender.Thiscanresultinchangingfees,changinginterestrates,alteredcreditlinecommitments,orevendenial.Repricingriskistheriskofchangesininterestratescharged(earned)atthetimeafinancialcontract’srateisreset.Aborrowerthatisrenewingacreditwillfacecurrentmarketconditionsonthebaserateusedforfinancing,atruefloating-rate.

8.5 CreditSpreads.Whatisacreditspread?Whatcreditratingchangeshavethemostprofoundimpactonthecreditspreadpaidbycorporateborrowers?

Thecostofdebtchangeswithcreditquality,asacreditspreadisaddedtothebasicTreasuryrateorLIBORforthematurityinquestion.Thecostsofcreditquality—creditspreads—arequiteminorforborrowersofinvestmentgradebutrisedramaticallyforspeculativegradeborrowers.

8.6 InvestmentGradeversusSpeculativeGrade.Whatdothegeneralcategoriesofinvestmentgradeandspeculativegraderepresent?

Althoughthereisobviouslyawidespectrumofcreditratings,thedesignationofinvestmentgradeversusspeculativegradeisextremelyimportant.Aninvestmentgradeborrower(Baa3,BBB-,andabove)isconsideredahighqualityborrowerthatisexpectedtobeabletorepayanewdebtobligationinatimelymannerregardlessofmarketeventsorbusinessperformance.Aspeculativegradeborrower(Ba1orBB+andbelow)isbelievedtobeariskierborrowerand,dependingonthenatureofamarketdownturnorbusinessshock,mayhavedifficultyservicingnewdebt.

8.7 SovereignDebt.Whatissovereigndebt?Whatspecificcharacteristicofsovereigndebtconstitutesthegreatestrisktoasovereignissuer?

Debtissuedbygovernments—sovereigndebt—ishistoricallyconsidereddebtofthehighestquality,higherthanthatofnongovernmentborrowerswithinthatsamecountry.Thisqualitypreferencestemsfromtheabilityofagovernmenttotaxitspeopleand,ifneedbe,printmoremoney.Althoughthefirstmaycausesignificanteconomicharmintheformofunemployment,andthesecondsignificantfinancialharmintheformofinflation,theyarebothtoolsavailabletothesovereign.Thegovernmentthereforehastheabilitytoserviceitsowndebt,onewayoranother,whenthatdebtisdenominatedinitsowncurrency.Whenthatdebtisdenominatedinaforeigncurrency,however,servicingthatdebtcanpotentiallyposeagreatrisktothesovereignissuer.

8.8 Floating-RateLoanRisk.Whydoborrowersoflowercreditqualityoftenfindtheiraccesslimitedtofloatingrateloans?

Asopposedtofixedrateloans,wherethelenderacceptsboththeriskofchanginginterestratesandchangingcreditqualityoftheborroweronloanorigination,afloating-rateloanshiftsinterestraterisktotheborrower.Lendersarenotgenerallywillingtoacceptbothriskswhenlendingtolowercreditqualityborrowers.

8.9 InterestRateFutures.Whatisaninterestratefuture?Howcantheybeusedtoreduceinterestrateriskbyaborrower?

Interestratefuturesarerelativelywidelyusedbyfinancialmanagersandtreasurersofnonfinancialcompanies.Theirpopularitystemsfromthehighliquidityoftheinterestratefuturesmarkets,theirsimplicityinuse,andtheratherstandardizedinterestrateexposuresmostfirmspossess.

Ifafinancialmanagerwereinterestedinhedgingafloatingrateinterestpaymentdueatashort-termfuturedate,shewouldneedtosellafuture,totakeashortposition.Thisstrategyisreferredtoasashortpositionbecausethemanagerissellingsomethingshedoesnotown(asinshortingcommonstock).IfinterestratesrisebyMarch,asthemanagerfears,thefuturespricewillfallandshewillbeabletoclosethepositionataprofit.Thisprofitwillroughlyoffsetthelossesassociatedwithrisinginterestpaymentsonherdebt.Ifthemanageriswrong,however,andinterestratesactuallyfallbythematuritydate,causingthefuturespricetorise,shewillsufferalossthatwillwipeoutthe“savings”derivedfrommakingalowerfloatingrateinterestpaymentthansheexpected.Sobysellingthefuturescontract,themanagerlocks-inaninterestrate.

8.10 InterestRateFuturesStrategies.Whatwouldbethepreferredstrategyforaborrowerpayinginterestonafuturedateiftheyexpectedinterestratestorise?

Theyshouldsellaninterestratefutures—takeashortposition.

8.11 ForwardRateAgreement.Howcanabusinessfirmthathasborrowedonafloating-ratebasisuseaforwardrateagreementtoreduceinterestraterisk?

Aforwardrateagreement(FRA)isaninterbank-tradedcontracttobuyorsellinterestratepaymentsonanotionalprincipal.Thesecontractsaresettledincash.ThebuyerofanFRAobtainstherighttolockinaninterestrateforadesiredtermthatbeginsatafuturedate.ThecontractspecifiesthattheselleroftheFRAwillpaythebuyertheincreasedinterestexpenseonanominalsum(thenotionalprincipal)ofmoneyifinterestratesriseabovetheagreedrate,butthebuyerwillpaythesellerthedifferentialinterestexpenseifinterestratesfallbelowtheagreedrate.Maturitiesavailablearetypically1,3,6,9,and12months,muchliketraditionalforwardcontractsforcurrencies.

8.12 PlainVanilla.Whatisaplain-vanillainterestrateswap?Areswapsasignificantsourceofcapitalformultinationalfirms?

Aplain-vanillainterestrateswapisaswaptopayfixed/receivefloating,oralternatively,payfloating/receivefixed.Theplain-vanillainterestrateswapisnotasourceofcapital;itonlyalterstheinterestratepriceonrepaymentofatheoretical—notional—debtprincipal.

8.13 SwapsandCreditQuality.Ifinterestrateswapsarenotthecostofgovernmentborrowing,whatcreditqualitydotheyrepresent?

Althoughinprincipletheswapmarketdoesnot“price”or“trade”creditquality,thefundamentalfixedratesofinterestusedbytheswapmarketarebasedonAAcreditqualityborrowers.Thefixedratesavailableintheswapmarketwillthereforealwaysreflectthecurrentgovernmentandcorporateyieldcurvesintheappropriatecurrencymarket.

8.14 LIBORFlat.Whydofixed-for-floatinginterestrateswapsneverswapthecreditspreadcomponentonafloatingrateloan?

Interestrateswapsarenotsourcesofcapitaland,therefore,arenotintendedtopricedebtasamarketorbankerwouldinassessingaborrower’screditquality.Instead,theswapmarketonlyalterstherepaymentmechanismofexistingdebt.Sincefloating-rateloansarepricedatLIBOR+acreditriskpremium,andthemarketisnotassessingcreditrisk,thecreditriskpremiumadjustmenttoLIBORoninterestrateswapsiszeroorflat.

8.15 DebtStructureSwapStrategies.Howcaninterestrateswapsbeusedbyamultinationalfirmtomanageitsdebtstructure?

Allcompanieswillpursueatargetdebtstructurethatcombinesmaturity,currencyofcomposition,andfixed/floatingpricing.Thefixed/floatingobjectiveisoneofthemostdifficultformanycompaniestodeterminewithanyconfidence,andtheyoftenjusttrytoreplicateindustryaverages.

Companieswhichhaveveryhighcreditqualityandthereforeadvantagedaccesstothefixed-ratedebtmarkets,companieswithAorAAratingslikeWalmartorIBM,oftenraiselargeamountsofdebtinlongmaturitiesatfixedrates.Theythenusetheplain-vanillaswapmarkettoalterselectiveamountsoftheirfixed-ratedebtintofloating-ratedebttoachievetheirdesiredobjective.Swapsallowthemtoalterthefixed/floatingcompositionquicklyandeasilywithouttheoriginationandregistrationfeesofthedirectdebtmarkets.

Companiesoflowercreditquality,sometimesthoseoflessthaninvestmentgrade,oftenfindthefixed-ratedebtmarketnotopentothem.Gettingfixed-ratedebtiseitherimpossibleortoocostly.Theywillgenerallyraisetheirdebtatfloating-ratesandthenperiodicallyevaluatewhethertheplain-vanillaswapmarketoffersanyattractivealternativestoswapfrompaying-floatingtopaying-fixed.Theplain-vanillaswapmarketisofcoursealsofrequentlyusedbymanyfirmstoaltertheirfixed/floatingdebtstructuretochanginginterestrateexpectations.

8.16 CostBasedSwapStrategies.Howdocorporateborrowersuseinterestrateorcross-currencyswapstoreducethecostsoftheirdebt?

Allfirmsarealwaysinterestedinopportunitiestolowerthecostoftheirdebt.Theplain-vanillaswapmarketisonehighlyaccessibleandlowcostmethodofdoingso.

Theselowercostsachievedthroughtheplain-vanillaswapmarketmaysimplyreflectshort-termmarketimperfectionsandinefficienciesorthecomparativeadvantagesomeborrowershaveinselectedmarketsviaselectivefinancialserviceproviders.Thesavingsmaybelarge—30,40,oreven50basispointsonoccasion—orquitesmall.Itisuptothemanagementofthefirmanditscorporatetreasurytodeterminehowmuchsavingsisneededtospendthetimeandeffortinexecutingtheswaps.Bankspromotetheswapmarketandwillregularlymarketdealstocorporatetreasuries.Acorporatetreasureronceremarkedtotheauthorthat“unlesstheproposedstructureordealcansaveme15or20basispoints,ataminimum,donotbothercallingmetopushthedeal.”

Theusualmotivationforacurrencyswapistoreplacecashflowsscheduledinanundesiredcurrencywithflowsinadesiredcurrency.Thedesiredcurrencyisprobablythecurrencyinwhichthefirm’sfutureoperatingrevenueswillbegenerated.Firmsoftenraisecapitalincurrenciesinwhichtheydonotpossesssignificantrevenuesorothernaturalcashflows.Thereasontheydosoiscost;specificfirmsmayfindcapitalcostsinspecificcurrenciesattractivelypricedtothemunderspecialconditions.Havingraisedthecapital,however,thefirmmaywishtoswapitsrepaymentintoadifferentcurrencyoneinwhichitwillhavefutureoperatingrevenues(cashinflows).

8.17 CrossCurrencySwaps.WhywouldonecompanywithinterestpaymentsdueinpoundssterlingwanttoswapthosepaymentsforinterestpaymentsdueinU.S.dollars?

ItmightbethatthecompanyinitscontinuingbusinessreceivedregularcashinflowsinU.S.dollarsandwouldprefertomatchthecurrencyinflowswithasame-currencycashoutflow.Swappingpoundssterlinginterestpaymentsfordollarinterestpaymentswouldfulfillthatobjective.

8.18 ValueSwingsinCrossCurrencySwaps.Whyaretheresignificantlylargerswingsinthevalueofacrosscurrencyswapthanthereisinaplain-vanillainterestrateswap?

Cross-currencyswapsaresubjecttobothchangesininterestratesandchangesinexchangerates.Thetworiskstogethercombinetocausepotentiallylargeswingsintherelativelegsoftheswapstructure.

8.19 UnwindingaSwap.Howdoesacompanycancelorunwindaswap?

Unwindingacurrencyswaprequiresdiscountingtheremainingcashflowsundertheswapagreementatcurrentinterestrates,thenconvertingthetargetcurrencybacktothehomecurrencyofthefirm.

8.20 CounterpartyRisk.Howdoesorganizedexchangetradinginswapsremoveanyriskthatthecounterpartyinaswapagreementwillnotcompletetheagreement?

Counterpartyr