Corporate financial managers can use swaps to arrange complex, innovative financings that reduce borrowing costs and increase control over interest rate risk and foreign currency exposure. For example, General Electric points out in its 2007 Annual Report (p. 100) that it uses swaps and other derivatives to hedge risk:
We use interest rate swaps, currency derivatives and commodity derivatives to reduce the variability of expected future cash flows associated with variable rate borrowings and commercial purchase and sale transactions, including commodities. We use interest rate swaps, currency swaps and interest rate and currency forwards to hedge the fair value effects of interest rate and currency exchange rate changes on local and nonfunctional currency denominated fixed-rate borrowings and certain types of fixed-rate assets. We use currency swaps and forwards to protect our net investments in global operations conducted in non-U.S. dollar currencies.
As a result of the deregulation and integration of national capital markets and extreme interest rate and currency volatility, the swaps market has experienced explosive growth, with the Bank for International Settlements (BIS) estimating outstanding interest rate and currency swaps as of June 30, 2007, of $320.6 trillion.1 Few Eurobonds are issued without at least one swap behind them to give the borrower less expensive or in some way more desirable funds.
This section discusses the structure and mechanics of the two basic types of swaps—interest rate swaps and currency swaps—and shows how swaps can be used to achieve diverse goals. Swaps have had a major impact on the treasury function, permitting firms to tap new capital markets and to take further advantage of innovative products without an increase in risk. Through the swap, they can trade a perceived risk in one market or currency for a liability in another. The swap has led to a refinement of risk management techniques, which in turn has facilitated corporate involvement in international capital markets.
Interest Rate Swaps
An interest rate swap is an agreement between two parties to exchange U.S. dollar interest payments for a specific maturity on an agreed-upon notional amount. The term notional refers to the theoretical principal underlying the swap. Thus, the notional principal is simply a reference amount against which the interest is calculated. No principal ever changes hands. Maturities range from less than a year to more than 15 years; however, most transactions fall within a two-year to 10-year period. The two main types are coupon swaps and basis swaps. In a coupon swap, one party pays a fixed rate calculated at the time of trade as a spread to a particular Treasury bond, and the other side pays a floating rate that resets periodically throughout the life of the deal against a designated index. In a basis swap, two parties exchange floating interest payments based on different reference rates. Using this relatively straightforward mechanism, interest rate swaps transform debt issues, assets, liabilities, or any cash flow from type to type and—with some variation in the transaction structure—from currency to currency.
The most important reference rate in swap and other financial transactions is the London Interbank Offered Rate (LIBOR). LIBOR is the average interest rate offered by a specific group of multinational banks in London (selected by the British Bankers Association for their degree of expertise and scale of activities) for U.S. dollar deposits of a stated maturity and is used as a base index for setting rates of many floating rate financial instruments, especially in the Eurocurrency and Eurobond markets. A Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside its country of origin. For example, a dollar on deposit in London is a Eurodollar. A Eurobond is a bond sold outside the country in whose currency it is denominated. So, for example, a dollar bond sold in Paris by IBM would be a Eurobond. Eurobonds can carry either fixed rates or floating rates. Fixed-rate bonds have a fixed coupon, whereas floating-rate issues have variable coupons that are reset at fixed intervals, usually every three to six months. The new coupon is set at a fixed margin above a mutually agreed-upon reference rate such as LIBOR.
The Classic Swap Transaction.
Counterparties A and B both require $100 million for a five-year period. To reduce their financing risks, counterparty A would like to borrow at a fixed rate, whereas counterparty B would prefer to borrow at a floating rate. Suppose that A is a company with a BBB rating and B is a AAA-rated bank. Although A has good access to banks or other sources of floating-rate funds for its operations, it has difficulty raising fixed-rate funds from bond issues in the capital markets at a price it finds attractive. By contrast, B can borrow at the finest rates in either market. The cost to each party of accessing either the fixed-rate or the floatingrate market for a new five-year debt issue is as follows:
Counterparty A: BBB-rated
6-month LIBOR + 0.5%
Counterparty B: AAA-rated
It is obvious that there is an anomaly between the two markets: One judges that the difference in credit quality between a AAA-rated firm and a BBB-rated firm is worth 150 basis points; the other determines that this difference is worth only 50 basis points (a basis point equals 0.01%). Through an interest rate swap, both parties can take advantage of the 100 basis-point spread differential.
To begin, A will take out a $100 million, five-year floating-rate Eurodollar loan from a syndicate of banks at an interest rate of LIBOR plus 50 basis points. At the same time, B will issue a $100 million, five-year Eurobond carrying a fixed rate of 7%. A and B then will enter into the following interest rate swaps with BigBank. Counterparty A agrees that it will pay BigBank 7.35% for five years, with payments calculated by multiplying that rate by the $100 million notional principal amount. In return for this payment, BigBank agrees to pay A six-month LIBOR (LIBOR6) over five years, with reset dates matching the reset dates on its floating-rate loan. Through the swap, A has managed to turn a floating-rate loan into a fixed-rate loan costing 7.85%.
In a similar fashion, B enters into a swap with BigBank whereby it agrees to pay six-month LIBOR to BigBank on a notional principal amount of $100 million for five years in exchange for receiving payments of 7.25%. Thus, B has swapped a fixed-rate loan for a floating-rate loan carrying an effective cost of LIBOR6 minus 25 basis points.
Why would BigBank or any financial intermediary enter into such transactions? The reason BigBank is willing to enter into such contracts is more evident when looking at the transaction in its entirety.