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©2012PearsonEducation,Inc.Chapter21InterestRateandForeignCurrencySwapsQUESTIONS1.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?Chapter21:InterestRateandForeignCurrencySwaps©2012PearsonEducation,Inc.2Answer: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?Answer:Ifacustomerwantsthefinancialintermediarytodoacurrencyswapinwhichthefinancialintermediarywillpaytheinterestandprincipalonthecustomer’soutstandingbond,whichhasaninterestratethatisdifferentfromtheinterestratethattheintermediaryisquoting,thefinancialintermediarywillalsohavetoadjustthebasispointsonthecashflowsofthecurrencyintheswapthatthecustomerispaying.Onecannotsimplyaddtheadditionalbasispointsthatthefinancialintermediaryispayingtotheratethatthecustomerwillpay,ifthelevelsoftheinterestratesonthetwocurrenciesaredifferent,becauseabasispointinthefutureforacurrencythatisdepreciatinginvalueisworthlessthanabasispointinthefutureforacurrencythatisappreciatinginvalue.Thecorrectprocedurerequiresthatonetakethepresentvalueoftheextrainterestratepaymentsthatthefinancialintermediaryispayinginonecurrency,convertthatamountintothecurrencythatthe