Dual Currency Bond Swaps.

Another variant on the currency swap theme is a currency swap involving a dual currency bond—one that has the issue’s proceeds and interest payments stated in foreign currency and the principal repayment stated in dollars. An example of a dual currency bond swap is the one involving the Federal National Mortgage Association (FNMA, or Fannie Mae). On October 1, 1985, FNMA agreed to issue 10-year, 8% coupon debentures in the amount of ¥50 billion (with net proceeds of ¥49,687,500,000) and to swap these yen for just over $209 million (an implied swap rate of ¥237.5479/$1). In return, Fannie Mae agreed to pay interest averaging about $21 million annually and to redeem these bonds at the end of 10 years at a cost of $240,400,000. Exhibit 9.8 shows the detailed yen and dollar cash flows associated with this currency swap. The net effect of this swap was to give Fannie Mae an all-in dollar cost of 10.67% annually. In other words, regardless of what happened to the yen:dollar exchange rate in the future, Fannie Mae’s dollar cost on its yen bond issue would remain at 10.67%. The 10.67% figure is the interest rate that just equates the dollar figures in column 2 of Exhibit 9.8 to zero.

Let us illustrate the mechanics of this swap. Note that at the end of the first year, FNMA is obligated to pay its bondholders ¥4 billion in interest (an 8% coupon payment on a ¥50 billion a face value debenture). To satisfy this obligation, FNMA pays $18,811,795 to Nomura, a Japanese investment bank, and Nomura in turn makes the ¥4 billion interest payment. As column 3 of Exhibit 9.8 shows, FNMA has effectively contracted with Nomura to buy ¥4 billion forward for delivery in one year at a forward rate of ¥212.6325.

Similarly, FNMA satisfies its remaining yen obligations (shown in column 1) by paying a series of dollar amounts (shown in column 2) to Nomura, which in turn makes the required yen payments. The exchange of fixed dollar payments in the future for fixed yen payments in the future is equivalent to a sequence of forward contracts entered into at the forward exchange rates shown in column 3. Since the actual spot rate at the time the swap was entered into (August 29, 1985) was about ¥240/$1, the implicit forward rates on these forward contracts reveal that the yen was selling at a forward premium relative to the dollar; that is, it cost fewer yen to buy a dollar in the forward market than in the spot market. The reason the yen was selling at a forward premium was the same reason that Fannie Mae was borrowing yen: At this time, the interest rate on yen was below the interest rate on dollars.

Exhibit 9.8 Cash Flows Associated with Yen Debenture Currency Swap

1 This figure is the ¥50 billion face amount net of issue expenses.

2 Net proceeds received after reimbursing underwriters for expenses of $150,000.

Since this particular issue was a dual currency bond, with the issue’s proceeds and interest payments stated in yen and the principal repayment stated in dollars, the final payment is stated in dollars only. However, it should be noted that by agreeing to a principal repayment of $240,400,000, instead of ¥50 billion, Fannie Mae actually was entering into the equivalent of a long-dated forward contract at an implicit forward rate of ¥207.9867/$1 (¥50 billion/$240,400,000).

Economic Advantages of Swaps

Swaps provide a real economic benefit to both parties only if a barrier exists to prevent arbitrage from functioning fully. Such impediments may include legal restrictions on spot and forward foreign exchange transactions, different perceptions by investors of risk and creditworthiness of the two parties, appeal or acceptability of one borrower to a certain class of investor, tax differentials, and so forth.3

Swaps also allow firms that are parties to the contracts to lower their cost of foreign exchange risk management by arbitraging their relative access to different currency markets. A borrower whose paper is much in demand in one currency can obtain a cost saving in another currency sector by raising money in the former and swapping the funds into the latter currency. A U.S. corporation, for example, may want to secure fixed-rate funds in euros in order to reduce its euro exposure, but it may be hampered in doing so because it is a relatively unknown credit in the German financial market. In contrast, a German company that is well established in its own country may desire floating-rate dollar financing but is relatively unknown in the U.S. financial market.

In such a case, a bank intermediary familiar with the funding needs and “comparative advantages” in borrowing of both parties may arrange a currency swap. The U.S. company borrows floating-rate dollars, and the German company borrows fixed-rate euros. The two companies then swap both principal and interest payments. When the term of the swap matures, say, in five years, the principal amounts revert to the original holder. Both parties receive a cost savings because they initially borrow in the market in which they have a comparative advantage and then swap for their preferred liability. In general currency, swaps allow the parties to the contract to arbitrage their relative access to different currency markets. A borrower whose paper is much in demand in one currency can obtain a cost saving in another currency sector by raising money in the former and swapping the funds into the latter currency.

Currency swaps are, therefore, often used to provide long-term financing in foreign currencies. This function is important because in many foreign countries longterm capital and forward foreign exchange markets are notably absent or not well developed. Swaps are one vehicle that provides liquidity to these markets.

In effect, swaps allow the transacting parties to engage in some form of tax, regulatory-system, or financial-market arbitrage. If the world capital market were fully integrated, the incentive to swap would be reduced because fewer arbitrage opportunities would exist. However, even in the United States, where financial markets function freely, interest rate swaps are very popular and are credited with cost savings.

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

9.2 Interest Rate Forwards and Futures

In addition to swaps, companies can use a variety of forward and futures contracts 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.

Forward Forwards

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.

Application  Telecom Argentina Fixes a Future Loan Rate

Suppose that Telecom Argentina needs to borrow $10 million in six months for a three-month period. It could wait six months and borrow the money at the then-current interest rate. Rather than risk a significant rise in interest rates over the next six months, however, Telecom Argentina decides to enter into a forward forward with Daiwa Bank that fixes this rate at 8.4% per annum. This contract guarantees that six months from today, Daiwa Bank will lend Telecom Argentina $10 million for a three-month period at a rate of 2.1% (8.4%/4). In return, nine months from today, Telecom Argentina will repay Daiwa the principal plus interest on the loan, or $10,210,000 ($10 million X 1.021).

The forward forward rate on a loan can be found through arbitrage. For example, suppose that a company wishes to lock in a six-month rate on a $1 million Eurodollar deposit to be placed in three months. It can buy a forward forward or it can create its own. To illustrate this process, suppose that the company can borrow or lend at LIBOR. Then the company can derive a three-month forward rate on LIBOR6 by simultaneously borrowing the present value of $1 million for three months and lending that same amount of money for nine months. If three-month LIBOR (LIBOR3) is 6.7%, the company will borrow $1,000,000/(1 + 0.067/4) = $983,526 today and lend that same amount for nine months. If nine-month LIBOR (LIBOR9) is 6.95%, at the end of nine months, the company will receive $983,526 X (1 + 0.0695 × 3/4) = $1,034,792. The cash flows on these transactions are

Notice that the borrowing and lending transactions are structured so that the only net cash flows are the cash outlay of $1,000,000 in three months and the receipt of $1,034,792 in nine months. These transactions are equivalent to investing $1,000,000 in three months and receiving back $1,034,792 in nine months. The interest receipt of $34,792, or 3.479% for six months, is equivalent to a rate of 6.958% per annum.

The process of arbitrage will ensure that the actual forward rate for LIBOR6 in three months will almost exactly equal the “homemade” forward forward rate.

Forward Rate Agreement

In recent years, forward forwards have been largely displaced by the forward rate agreement. A forward rate agreement (FRA) 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. It is analogous to a forward foreign currency contract but instead of exchanging currencies, the parties to an FRA agree to exchange interest payments. As of June 30, 2007, the estimated notional amount of FRAs outstanding was $25.6 trillion.4

The formula used to calculate the interest payment on a LIBOR-based FRA is

where days refers to the number of days in the future interest period. The discount reflects the fact that the FRA payment occurs at the start of the loan period, whereas the interest expense on a loan is not paid until the loan’s maturity. To equate the two, the differential interest expense must be discounted back to its present value using the actual interest rate. The example of Unilever shows how a borrower can use an FRA to lock in the interest rate applicable for a future loan.

Application  Unilever Uses an FRA to Fix the Interest Rate on a Future Loan

Suppose that Unilever needs to borrow $50 million in two months for a six-month period. To lock in the rate on this loan, Unilever buys a ‘’2 × 6” FRA on LIBOR at 6.5% from Bankers Trust for a notional principal of $50 million. This means that Bankers Trust has entered into a two-month forward contract on six-month LIBOR. Two months from now, if LIBOR6 exceeds 6.5%, Bankers Trust will pay Unilever the difference in interest expense. If LIBOR6 is less than 6.5%, Unilever will pay Bankers Trust the difference.

Assume that in two months LIBOR6 is 7.2%. Because this rate exceeds 6.5%, and assuming 182 days in the six-month period, Unilever will receive from Bankers Trust a payment determined by Equation 9.1 of

In addition to fixing future borrowing rates, FRAs can also be used to fix future deposit rates. Specifically, by selling an FRA, a company can lock in the interest rate applicable for a future deposit.

4 “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2007—Final Results,” Bank for International Settlements, December 2007, p. 21