International-Financial-Management---Bekaert-2e---Solutions---Ch21.doc

International-Financial-Management---Bekaert-2e---Solutions---Ch21.doc

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9

Chapter21:

InterestRateandForeignCurrencySwaps

Chapter 21

InterestRateandForeignCurrencySwaps

QUESTIONS

1.Howdoesaninterestrateswapwork?

Inparticular,whatisthenotionalprincipal?

Answer:

AninterestrateswapisanagreementbetweencounterpartiesthatallowsanMNCtochangethenatureofitsdebtfromafixedinterestratetoafloatinginterestrateorfromafloatinginterestratetoafixedinterestrate.Onecounterpartytothebasicinterestrateswappaysafixedamountofinterestonanotionalprincipaltotheothercounterparty,whichinturnispayingthefloatinginterestratecashflowsonthesamenotionalamounttothefirstcounterparty.Thetermnotionalindicatesthebasicprincipalamountonwhichthecashflowsoftheinterestrateswapdepend.Unlikeacurrencyswap,noexchangeofprincipalisnecessarybecausetheprincipalisanequalamountofthesamecurrency.Usually,onlyanetinterestpaymentismadedependinguponwhetherthefixedinterestratestatedintheswapishigherorlowerthanthefloatinginterestrate.

2.Whatisacurrencyswap?

Describethestructureofandrationaleforitscashflows.

Answer:

Acurrencyswapisessentiallyanagreementbetweentwopartiestoexchangethecashflowsoftwolong-termbondsdenominatedindifferentcurrencies.Thepartiesexchangeinitialprincipalamountsinthetwocurrenciesthatareequivalentinvaluewhenevaluatedatthespotexchangerate.Simultaneously,thepartiesagreetopayinterestonthecurrencytheyinitiallyreceive,toreceiveinterestonthecurrencytheyinitiallypay,andtoreversetheexchangeofprincipalamountsatafixedfuturedate.

3.Whatisacreditdefaultswap?

Whathappensintheeventofdefault?

Answer:

Acreditdefaultswapisessentiallyabilateralinsurancecontractbetweenaprotectionbuyerandaprotectionsellertoprotectagainstdefaultonaspecificbondorloanissuedbyacorporationorsovereign（the“referenceentity”）.Theprotectionbuyerpayssemi-annualorannualinsurancepremiumstotheprotectionseller.Inreturn,whenthereisadefaultevent,theprotectionsellertransfersvaluetotheprotectionbuyer.Valueistransferredeitherthroughphysicalsettlementorcashsettlement.Ifthereisphysicalsettlement,theprotectionbuyerdeliversthedefaultedbondtotheprotectionsellerwhopaysthefaceamountofthereferencedbond.Ifthereiscashsettlement,theprotectionsellerpaysthebuyerthedifferencebetweenthefacevalueofthebondandthevalueofthedefaultedbond.

4.Banksquoteinterestrateandcurrencyswapsusingthe6-monthLIBORasabasisforbothtransactions.Howcanabankmakemoneyifitdoesnotspeculateonmovementsineitherinterestratesorexchangerates?

Answer:

Banksquotethefixedsideoftheswapwithabid-askspread.Whentheypaythefixed-ratesideoftheswap,theydosoatalowerratethanwhentheyreceivethefixed-ratesideoftheswapfromtheircounterparty.Thus,iftheyareabletobalancethetransactions,beingbothapayerofthefixedrateandareceiverofthefixedrateforthesamegrossamounts,theyearnthebid-askspread.Thiscanbeasubstantialamountofmoney.

5.WhatistheAICofabondissue?

Answer:

Theall-incost（AIC）ofabondissueistheinternalrateofreturnthatequatesthepresentvalueofallthefutureinterestandprincipalpaymentstothenetproceeds（facevalueminusfees）receivedbytheissuer.

6.Whatisacomparativeadvantageinborrowing,andhowcoulditarise?

Answer:

Comparativeadvantageinborrowingmeansthattheratiooftheborrowingcostinonecurrency（oneplustheinterestrate）totheborrowingcostsinanothercurrencyisnotthesamefortwocompanies.Thecompanywiththelowerratiohasacomparativeadvantageinborrowingthenumeratorcurrencyeventhoughitsabsoluteborrowingcostsmaybehigherthantheothercompany’scostsineachcurrency.Suchdifferencesimplythatthecompaniesshouldborrowinthecurrencyinwhichtheyhaveacomparativeadvantage,andswapintothecurrencyofchoicebasedonotherconsiderationssuchasforeignexchangerisk.

Comparativeborrowingadvantagesarisebecauseinstitutionaldifferencesacrosscountriesleadtodebtpricingthatisslightlydifferent,dependingontheultimateholderofthedebtanditscurrencyofdenomination.Someofthesepricingdifferencesareduetothedifferentwayscreditrisksareanalyzedaroundtheworld.Essentially,thesedifferencesamounttoamarketinefficiencythatcanbeexploitedforprofit.Theresultisthatsomecompaniescanmoreeasilyissuedebtinsomecurrenciesthaninothercurrencies.

7.Whatisbasispointadjustment?

Whyisitnotappropriatesimplytoaddthebasispointdifferentialassociatedwiththefirstcurrencytothequotedswapratethatthefirmwillpay?