Page 157 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 2. Cross-currency Floating-to-fixed Swap: Often a non-US dollar based bank has medium-
term floating assets denominated in dollars. The bank needs to fund its medium-term
floating dollar assets with medium-term floating dollar liabilities. However, it can only
raise funds cheaply on a fixed rate basis in its domestic currency. A swap is a way to solve
this problem. For example, counterparty A is domiciled in the United States, and
counterparty B is domiciled in Switzerland. In this case, counterparty A is in a position to
borrow cheaply in US dollar on a floating rate basis and counterparty B is in a position to
borrow cheaply on a fixed rate basis in Swiss francs. Each counterparty can use its
comparatively strong borrowing capacity to reduce the overall cost of funds by entering
into a currency swap.
Counterparty A can borrow floating rate funds in the US dollar money market at LIBOR
plus a margin. Counterparty B can borrow fixed rate funds cheaply in Swiss francs by way
of a bond issue. During the swap, counterparty B can pay floating rate dollars to
Counterparty A to service the dollar loan. Counterparty A can pay fixed rate Swiss francs
to counterparty B to service the Swiss francs loan.
3. Cross-currency Floating-floating (Basis) Swaps: This type of currency swap is used as an
alternative to the foreign exchange market. It does not tend to be widely used because of
capital adequacy requirements, but it is certainly worth knowing how to use it. Its main
advantage is that the counterparties can obtain a term commitment which would roll over
an effective forward foreign exchange contract according to an agreed period.
4. Basis Swaps: Basis swaps involve an exchange of floating rate payments calculated on
different basis. The structure of a basis swap is the same as the straight interest rate swap,
with the exception that floating interest calculated on one basis is exchanged for floating
interest calculated on a different basis. Examples of basis swaps include LIBOR-LIBOR
(3 months against 6 months, etc.), Prime-LIBOR and CP-LIBOR.

5. Amortizing Swaps: Amortizing swaps are very popular for lease based transaction where
the principal reduces annually or even more frequently. For example, Company A has
borrowed $9 million to buy a building. They have agreed with their bankers to pay back
the loan, principal plus interest at 8.50% fixed, over 3 years. Company A thinks that
interest rates are going to fall over the period and thus would prefer to pay a floating rate
rather than fixed rate. Company A can enter into a swap with the bank in which the
notional principal decreases on each of the amortization dates.

6. Roller-coaster Swaps: A variation on the amortizing swap is the roller-coaster swap
where the principal involved increases and decreases over the life of the swap.
7. LIBOR Adjustments and Off-market Coupons: An off-market coupon or non-par value
swap is one which has a fixed rate above or below the currency market rate. In this case, an
up-front payment is made which is equal to the present value of the annuity based on the
difference between the off-market coupon swap rate and the current market rate, multiplied
by the notional principal amount.
8. LIBOR-in-arrears Swaps: In a generic swap, LIBOR is normally set 6 months and 2 days
before a payment date; however, it is possible to structure a swap so that LIBOR is fixed 2
days before the payment date. This structure may be advantageous when the yield curve
is positively sloped and the implied forward rates are higher than the physical yield
curve, but at the same time, the swap user expects that short-term rates will remain stable
or decrease.
9. Participation Swaps: The participation swap is a new hybrid product, which incorporates
the advantages of the swap and cap/floor products. Under this arrangement, an interest
rate swap is transacted to cover a portion of the notional principal and an interest rate cap
is transacted to cover the remainder of the notional principal. The fixed rate on the swap

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