Interest rates and currency swaps

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-1
INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Fourth Edition
Chapter Objective:
This chapter discusses currency and interest rate
swaps, which are relatively new instruments for
hedging long-term interest rate risk and foreign
exchange risk.
06Chapter Six
Interest Rate &
Currency Swaps

Chapter Outline
 Types of Swaps
 Size of the Swap Market
 The Swap Bank
 Swap Market Quotations
 Interest Rate Swaps
 Currency Swaps
 Variations of Basic Interest Rate and Currency Swaps
 Risks of Interest Rate and Currency Swaps
 Is the Swap Market Efficient?
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps
 Types of Swaps
 The Swap Bank
 Currency Swaps

 CHAPTER 5 INTRODUCED forward contracts as a
vehicle for hedging exchange rate risk; chapter 7
introduced futures and options contracts on foeign
exchange as alternative tools to hedge foreign exchange
exposure. These types of instruments seldom have terms
longer than a few years, however.
 In this chapter, we examine interest rate swaps, both
single-currency and cross-currency, which are techniques
for hedging long-term interest rate risk and foreign
exchange risk.

 The chapter begins with some useful definitions that
define and distinguish between interest rate and currency
swaps. Data on the size of the interest rate and currency
swap markets are presented.
 The next section illustrates the usefulness of interest rate
swaps. The following section illustrates the construction of
currency swaps.
 The chapter also details the risks confronting a swap
dealer in maintaining a portfolio of interest rate and
currency swaps and shows how swaps are priced.

Types of Swaps
 In interest rate swap financing, two parties, called
counterparties, make a contractual agreement to
exchange cash flows at periodic intervals.
 There are two types of interest rate swaps. One is a
single-currency interest rate swap. The name of
this type is typically shortened to interest rate
swap. The other type can be called a cross-
currency interest rate swap. This type is usually
just called a currency swap.

Definitions
 In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
 There are two types of interest rate swaps:
 Single currency interest rate swap
“Plain vanilla” fixed-for-floating swaps are often just called
interest rate swaps.
 Cross-Currency interest rate swap
This is often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.

“Plain vanilla” fixed-for-floating swaps
interest rate swaps.
 In the basic fixed-for-floating rate interest rate swap, one
counterparty exchanges the interest payments of a
floating-rate debt obligation for the fixed-rate interest
payments of the other counterparty. Both debt obligations
are denominated in the same currency. Some reasons for
using an interest rate swap are to better match cash
flows(inflows and outflows) and/or to obtain a cost
savings. There are many variants of the basic interest rate
swap, some of which are discussed below.

Currency swap
 In a currency swap, one counterparty exchanges the debt
service obligations of a bond denominated in one currency
for the debt service obligations of the other counterparty
denominated in another currency.
 The basic currency swap involves the exchange of fixed-
for-fixed rate debt service. Some reasons for using
currency swaps are to obtain debt financing in the
swapped denomination at a cost savings and/or to hedge
long-term foreign exchange rate risk. The International
Finance in Practice box “The World Bank’s First Curreny
Swap” discusses the first currency swap.

The World Bank’s First Currency Swap
 The World Bank frequently borrows in the national capital markets
around the world and in the Eurobond market. It prefers to borrow
currencies with low nominal interest rates, such as the deutsche mark
and the Swiss franc. In 1981, the World Bank was near the official
borrowing limits in these currencies but desired to borrow more. By
coincidence, IBM had a large amount of deutsche mark and Swiss
franc debt that it had incurred a few years ealier.
 The proceeds of these borrowings had been converted to dollars for
corporate use. Salomon Brothers convinced the World Bank to issue
Eurodollar debt with maturities matching the IBM debt in other to
enter into a currency swap with IBM.

 IBM agreed to pay the debt service (interest and principal)
on the World Bank’s Eurodollar bonds, and in turn the
World Bank agreed to pay the debt service on IBM’s
deutsche mark and Swiss franc debt. While the details of
the swap were not made public, both counterparties
benefited through a lower all-in cost (interest expense,
transaction costs, and services charges) than they
otherwise would have had. Additionally, the World Bank
benefited by developing an indirect way to obtain desired
currencies without going directly to the German and Swiss
capital markets.

 www.isda.org
 This is the website of the International Swaps and derivatives
association, Inc.
 As the International Finance in Practice box suggests, the market for
currency swaps developed first. Today, however, the interest rate
swap market is larger. Exhibit 6.1 provides some statistics on the size
and growth in the interest rate and currency swap markets. Size is
measured by notional principal, a reference amount of principal for
determining interest payments.
Size of the Swap Market

Exhibit 6.1 Size of Interest Rate
size of interest rate and currency swap markets:
Total Notional Principal Outstanding Amounts in Billions of U.S. Dollars
Year Interest Rate Swaps Currency Swaps
1995 12,811 1,197
1996 19,171 1,560
1997 22,291 1,824
1998 36,262 2,253
1999 43,936 2,444
2000 48,768 3,194
2001 58,897 3,942
2002 79,120 4,503
2003 111,209 6,371
2004(mid-year) 125,570 7,033

 The exhibit indicates that both markets have grown
significantly since 1995, but that the growth in interest rate
swaps has been by far more dramatic. The total amount of
interest rate swaps outstanding increased from $12,811
billion at year-end 1995 to $127.6 trillion by mid-year
2004, an increase of nearly 900 percent. Total outstanding
currency swaps increased 488 percent, from $1,197 billion
at year-end 1995 to over $7 trillion by mid-year 2004.

Size of the Swap Market
 In 2004 the notational principal of:
Interest rate swaps was $127,570 billion USD.
Currency swaps was $7,033 billion USD
 The most popular currencies are:
 U.S. dollar
 Japanese yen
 Euro
 Swiss franc
 British pound sterling

The Swap Bank
A swap bank is a generic term to describe a
financial institution that facilitates swaps
between counterparties.
The swap bank can serve as either a broker
or a dealer.
 As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
 As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay off their risk,
or match it with a counterparty.

Swap market Quotations
 Swap banks will tailor the terms of interests rate and currency swaps
to customers’ needs. They also make a market in generic “plain
vanilla” swaps and provide current market quotations applicable to
counterparties with Aa or Aaa credit ratings.
 Consider a basic U.S. dollar fixed-for- floating interest rate swap
indexed to dollar LIBOR. A swap bank will typically quote a fixed-
rate bid-ask spread (semiannual or annual ) versus three-month or six-
month dollar LIBOR flat, that is , no credit premium.
 Suppose the quote for a five-year swap with semiannual payments is
8.50-8.60 percent against six-month LIBOR flat. This means the swap
bank will pay semiannual fixed-rate dollar payments of 8.50 percent
against receiving six-month dollar LIBOR, or it will receive
semiannual fixed-rate dollar payments at 8.60 percent against paying
six-month dollar LIBOR.

Swap Market Quotations
 Swap banks will tailor the terms of interest rate
and currency swaps to customers’ needs
 They also make a market in “plain vanilla” swaps
and provide quotes for these. Since the swap
banks are dealers for these swaps, there is a bid-
ask spread.

Interest Rate Swap Quotations
Euro-€ £ Sterling Swiss franc U.S. $
Bid Ask Bid Ask Bid Ask Bid Ask
1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57
2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94
3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13
4 year 3.06 3.09 5.12 5.17 1.73 1.81 4.25 4.28
5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39
6 year 3.38 3.41 5.11 5.16 2.10 2.18 4.46 4.50
7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58
8 year 3.63 3.66 5.10 5.15 2.37 2.45 4.62 4.66
9 year 3.74 3.77 5.09 5.14 4.48 2.56 4.70 4.72
10 year 3.82 3.85 5.08 5.13 2.56 2.64 4.75 4.79
3.82–3.85 means the swap bank will pay
fixed-rate euro payments at 3.82%
against receiving euro LIBOR or it will
receive fixed-rate euro payments at
3.85% against receiving euro LIBOR

Basic Interest Rate Swaps
 EXAMPLE 6.2
 As an example of a basic interest rate swap, consider the following
example of a fixed-for-floating rate swap. Bank A is a AAA-rated
international bank located in the United Kingdom. The bank needs
$10,000,000 to finance floating-rate Eurodollar term loans to its
clients.
 It is considering issuing five-year floating-rate notes(FRNs) indexed
to LIBOR. Alternatively, the bank could issue five-year fixed-rate
Eurodollar bonds at 10 percent.
 The FRNs make the most sense for bank A, since it would be using a
floating-rate liability to finance a floating-rate asset. In this manner,
the bank avoids the interest rate risk associated with a fixed-rate issue.

 Company B is a BBB-rated U.S. company. It needs $10,000,000 to
finance a capital expenditure with a five-year economic life. It can
issue five-year fixed-rate bonds at a rate of 11.5 percent in the U.S.
bond market . Alternatively, it can issue five-year FRNs at LIBOR
plus.50 percent.
 The fixed-rate debt makes the most sense for company B because it
locks in a financing cost. The FRN alternative could prove very
unwise should LIBOR increase substantially over the life of the note,
and could possibly result in the project being unprofitable.
 A swap bank familiar with the financing needs of bank A and
Company B has the opportunity to set up a fixed-for-floating interest
rate swap that will benefit each counterparty and the swap bank.
Assume that the swap bank is quoting five-year U.S. dollar interest
rate swaps at 10.375-10.50 percent against LIBOR flat.

The key, or necessary condition, giving rise to the swap is that a quality
spread differential (QSD) exists. A QSD is the difference between
the default-risk premium differential on the fixed-rate debt and the
default-risk premium differential on the floating-rate debt. In general,
the former is greater than the latter. Financial theorists have offered a
variety of explanations for this phenomenon, none of which is
completely satisfactory.
Given that a QSD exists, it is possible for each counterparty to issue the
debt alternative that is least advantageous for it, then swap interest
payments, such that each counterparty ends up with the type of
interest payment desired, but at a lower all-in cost than it could arrange
on its own. EXHIBIT 6.2 Calculation of Quality Spread
Differentia Company B Bank A Differential
Fixed-rate 11.25% 10.00% 1.25%
Floating-rate LIBOR+.50% LIBOR .50%
QSD=.75%

 EXHIBIT 6.2 diagrams a possible scenario the swap bank could
arrange for the two counterparties.
 From Exhibit 6.2, we see that the swap bank has instructed company
B to issue FRNs at LIBOR plus .50 percent rather than the more
suitable fixed-rate debt at 11.25 percent. Company B passes through
to the swap bank 10.50% and receives LIBOR in return.
 In total, Company B pays 10.50% (to the swap bank) plus
LIBOR+.50% (to the floating-rate bondholders) and receives LIBOR
percent (from the swap bank) for an all-in cost of 11%.
 10.50%+LIBOR+.50% － LIBOR=11%
 Thus, through the swap, Company B has converted floating-rate debt
into fixed-rate debt at an all-in cost .25% lower than the 11.25% fixed
rate it could arrange on its own.

 Similarly, Bank A was instructed to issue fixed-rate debt at 10% rather than
the more suitable FRNs. Bank A passes through to the swap bank LIBOR and
receives 10.375% in return.
 In total, Bank A pays 10% (to the fixed-rate Eurodollar bondholders) plus
LIBOR%( to the swap bank) and receives 10.375%(from the swap bank) for
an all-in cost of LIBOR － .375%.
 10%+LIBOR － 10.375%=LIBOR － .375%
 Through the swap, Bank A has converted fixed-rate debt into floating-rate
debt at an all-in cost .375% lower than the floating rate of LIBOR it could
arrange on its own.
 The swap bank also benefits because it pays out less than it receives from
each counterparty to the other counterparty .It receives 10.50% (from
Company B)+LIBOR (from Bank A) and pays 10.375%(to Bank A) and
LIBOR (to Company B). The net inflow to the swap bank is .125%.

EXHIBIT 6. 3 Fixed-for-floating interest rate Swap
Issue Eurodollar
bonds @10%
Bank A AAA
U.K.
Issue FRNs in $
@LIBOR
Issue domestic
Bonds @11.25%
Company B
BBB
U.S.
Issue FRNs in $
@LIBOR+.50%
Swap
Bank
LIBOR LIBOR
10.375% 10.50%

Net Cash out Flows
Bank A Swap Bank Company B
Pays LIBOR
10%
10.375%
LIBOR
10.50%
LIBOR+.50%
Receives -10.375% -10.50%
-LIBOR
-LIBOR
Net LIBOR-.375% -.125% 11%

An Example of an Interest Rate Swap
 Consider this example of a “plain vanilla” interest
rate swap.
 Bank A is a AAA-rated international bank located
in the U.K. and wishes to raise $10,000,000 to
finance floating-rate Eurodollar loans.
 Bank A is considering issuing 5-year fixed-rate Eurodollar bonds
at 10 percent.
 It would make more sense to for the bank to issue floating-rate
notes at LIBOR to finance floating-rate Eurodollar loans.

Firm B is a BBB-rated U.S. company. It
needs $10,000,000 to finance an investment
with a five-year economic life.
 Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
 Alternatively, firm B can raise the money by issuing 5-
year floating-rate notes at LIBOR + ½ percent.
 Firm B would prefer to borrow at a fixed rate.

The borrowing opportunities of the two firms
are:
Company B Bank A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

The swap bank makes
this offer to Bank A: You
pay LIBOR – 1/8 % per
year on $10 million for 5
years and we will pay you
10 3/8% on $10 million
for 5 years
COMPANY B BANK A
Swap
Bank
LIBOR – 1/8%
10 3/8%
Bank
A

COMPANY B BANK A
Here’s what’s in it for Bank A:
They can borrow externally at
10% fixed and have a net
borrowing position of
-10 3/8 + 10 + (LIBOR – 1/8) =
LIBOR – ½ % which is ½ %
better than they can borrow
floating without a swap.
10%
½% of $10,000,000 =
$50,000. That’s quite
a cost savings per year
for 5 years.
Swap
Bank
LIBOR – 1/8%
10 3/8%
Bank
A

Company
B
The swap bank makes
this offer to company B:
You pay us 10½% per
years and we will pay
you LIBOR – ¼ % per
years.
Swap
Bank
10 ½%
LIBOR – ¼%
COMPANY B BANK A

COMPANY B BANK A
They can borrow externally at
LIBOR + ½ % and have a net
borrowing position of
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25%
which is ½% better than they can borrow floating.
LIBOR
+ ½%
Here’s what’s in it for B: ½ % of $10,000,000 =
$50,000 that’s quite a
cost savings per year for
5 years.
Swap
Bank
Company
B
10 ½%
LIBOR – ¼%

The swap bank makes
money too.
¼% of $10 million =
$25,000 per year for
5 years.
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
10 ½ - 10 3/8 = 1/8
¼
Swap
Bank
Company
B
10 ½%
LIBOR – ¼%LIBOR – 1/8%
10 3/8%
Bank
A
COMPANY B BANK A

Swap
Bank
Company
B
10 ½%
LIBOR – ¼%LIBOR – 1/8%
10 3/8%
Bank
A
B saves ½%A saves ½%
The swap bank makes ¼%
COMPANY B BANK A

 A Basic Currency Swap
 As an example of a basic currency swap, consider the following example.
 A U.S. MNC desire to finance a capital expenditure of its German
subsidiary.The project has an economic life of five years. The cost of the
project is €40,000,000. At the currency exchange rate of $1.30/€1, the parent
firm could raise $52,000,000 in the U.S. capital market by issuing five-year
bonds at 8%. The parent would then convert the dollars to euros to pay the
project cost.
 The German subsidiary would be expected to earn enough on the project to
meet the annual dollar debt service and to repay the pricipal in five years.
 The only problem with this situation is that a long-term transaction exposure
is created. If the dollar approciates substantially against the euro over the loan
period, it may be difficult for the German subsidiary to earn enough in euros
to service the dollar loan.
An Example of a Currency Swap

 An alternative is for the U.S. parent to raise €40,000,000
in the international bond market by issuing euro-
denominated Eurobonds. (The U.S. parent might instead
issue euro-denomonated foreign bonds in the German
capital market.) However, if the U.S. MNC is not well
known, it will have difficulty borrowing at a favorable rate
of interest. Suppose the U.S. parent can borrow
€40,000,000 for a term of five years at a fixed rate of 7%.
The current normal borrowing rate for a well-known firm
of equivalent creditworthiness is 6%.

 Assume a German MNC of equivalent creditworthiness has a mirror-
image financing need.It has a U.S. subsidiary in need of $52,000,000
to finance a capital expenditure with an economic life of five years.
The German parent could raise €40,000,000 in the German bond
market at a fixed rate of 6% and convert the funds to dollar to finance
the expenditure. Transaction exposure is created, however, if the euro
appreciates substantially against the dollar. In this event, the U.S.
subsidiary might have difficulty earning enough in dollars to meet the
debt service. The German parent could issue Eurodollar bonds, but
since it is not well known its borrowing cost would be , say , a fixed
rate of 9%.

 A swap bank familiar with the financing needs of the two MNCs
could arrange a currency swap that would solve the double problem of
each MNC, that is, be confronted with long-term transaction exposure
or borrow at a disadvantageous rate. Ths swap bank would instruct
each parent firm to raise funds in its national capital market where it is
well known and has a comparative advantage because of name or
brand recognition. Then the pricinpal sums would be exchanged
through the swap bank.
 Annually, the German subsidiary would remit to its U.S. parent
€2,400,000 in interest (6% of €40,000,000 ) to be passed through the
swap bank to the German MNC to meet the euro debt service. The
U.S. subsidiary of the German MNC would annually remit $4,160,000
in interest (8% of $ 52,000,000) to be passed through to the swap
bank to the U.S. MNC to meet the dollar debt service.

 At the debt retirement date, the subsidiaries would remit the pricipal
sums to their respective parents to be exchanged through the swap
bank in order to pay off the bond issues in the national capital
markets.
 Exhibit 6.4 demonstrates that there is a cost savings for each
counterparty because of their relative comparative adavntage in their
respective national capital markets.
 The U.S. MNC borrows euro at an all-in-cost (AIC) of 6 percent
through the currency swap instead of the 7% it would have to pay in
the Eurobond market.
 The German MNC borrows dollars at an AIC of 8% through the swap
instead of the 9% rate it would have to pay in the eurobond market.

EXHIBIT 6.4 $/ € Currency Swap
U.S.
Capital market
@8%
U.S.
MNC
Euro-denominated
Eurobond market
@7%
German
Capital market
@6%
German
MNC
Eurodollar
Eurobond market
@9%
Swap
Bank
€@6%
€@6%
$@8% $@8%

 Suppose a U.S. MNC wants to finance a
£10,000,000 expansion of a British plant.
 They could borrow dollars in the U.S. where they
are well known and exchange for dollars for
pounds.
 This will give them exchange rate risk: financing a
sterling project with dollars.
 They could borrow pounds in the international
bond market, but pay a premium since they are not
as well known abroad.

 If they can find a British MNC with a mirror-
image financing need they may both benefit from
a swap.
 If the spot exchange rate is S0($/£) = $1.60/£, the
U.S. firm needs to find a British firm wanting to
finance dollar borrowing in the amount of
$16,000,000.

Consider two firms A and B: firm A is a U.S.–based
multinational and firm B is a U.K.–based
multinational.
Both firms wish to finance a project in each other’s
country of the same size. Their borrowing
opportunities are given in the table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

$9.4%
$ £
Company B 10.0% 12.0%
Firm
B
$8% £12%
Swap
Bank
Firm
A
£11%
$8%
£12%

$8% £12%
$ £
Company B 10.0% 12.0%
Firm
B
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
A’s net position is to
borrow at £11%
A saves £.6%

$8% £12%
$ £
Company B 10.0% 12.0%
Firm
B
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
B’s net position is to
borrow at $9.4%
B saves $.6%

$8% £12%
$ £
Company B 10.0% 12.0%
Firm
B
The swap bank makes
money too:
At S0($/£) = $1.60/£, that
is a gain of $64,000 per
year for 5 years. The swap bank
faces exchange rate
risk, but maybe they
can lay it off (in
another swap).
1.4% of $16 million
financed with 1% of
£10 million per year
for 5 years.
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
$64,000
$224,000
–$160,000

The QSD
 The Quality Spread Differential represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
 There is no reason to presume that the gains will
be shared equally.
 In the above example, company B is less credit-
worthy than bank A, so they probably would have
gotten less of the QSD, in order to compensate the
swap bank for the default risk.

A is the more credit-worthy of the two firms.
Comparative Advantage
as the Basis for Swaps
$ £
Company B 10.0% 12.0%
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.
A pays 2% less to borrow in dollars than B
A pays .4% less to borrow in pounds than B:

B has a comparative advantage in borrowing in £.
$ £
Company B 10.0% 12.0%
B pays 2% more to borrow in dollars than A
B pays only .4% more to borrow in pounds than A:

A has a comparative advantage in borrowing in
dollars.
B has a comparative advantage in borrowing in
pounds.
If they borrow according to their comparative
advantage and then swap, there will be gains for
both parties.

Risks of Interest Rate and Currency Swaps
 Some of the major risks that a swap dealer confronts are discussed
here.
 Interest-rate risk refers to the risk of interest rates changing
unfavorably before the swap bank can lay off on an opposing
counterparty the other side of an interest rate swap entered into with a
counterparty.
 As an illustration, reconsider the interest rate swap example, Example
6.1. To recap, in that example, the swap bank earns a spread of .125%.
Company B passes through to the swap bank 10.50% per annum (0n
the notional principal of $10,000,000) and receives LIBOR percent in
return. Bank A passes through to the swap LIBOR percent and
receives 10.375% in return. Suppose the swap

 Suppose the swap bank entered into the position with Company B
first. If fixed rate increase substantially, say, by .50%, Bank A will not
be willing to enter into the opposite side of the swap unless it receives,
say, 10.875%. This would make the swap unprofitable for the swap
bank.
 Basis risk refers to a situation in which the floating-rates of the two
counterparties are not pegged to the same index.Any difference in the
indexes is known as the basis.For example, one counterparty could
have its FRNs pegged to LIBOR, while the other counterparty has its
FRNs pegged to the U.S. Treasury bill rate. In this event, the indexes
are not perfectly positively correlated and the swap may periodically
be unprofitable for the swap bank. In our example, this would occur if
the Treasury bill rate was substantially larger than LIBOR and the
swap bank receives LIBOR from one counterparty and pays the
treasury bill rate to the other.

 Exchange-rate risk refers to the risk the swap bank faces from
fluctuating exchange rates during the time it takes for the bank to lay
off a swap it undertakes with one counterparty with an opposing
counterparty.
 Credit risk is the major risk faced by a swap dealer. It refers to the
probability that a counterparty will default. The swap bank that stands
between the two counterparties is not obligated to the defaulting
counterparty, only to the nondefaulting counterparty. There is a
separate agreement between the swap bank and each counterparty.
 Mismatch risk refers to the difficulty of finding an exact opposite
match for a swap the bank has agreed to take. The mismatch may be
with respect to the size of the principal sums the counterparties need,
the maturity dates of the individual debt issues, or the debt service
dates.

 Sovereign risk refers to the probability that a country will impose
exchange restrictions on a currency involved in a swap. This may
make it very costly, or perhaps impossible, for a counterparty to fulfill
its obligation to the deale. In this event, provisions exist for
terminating the swap, which results in a loss of revenue for the swap
bank.
 To facilitate the operation of the swap market, the International Swaps
and Derivatives Association (ISDA) has standardized two swap
agreements. One is the “Interest Rate and Currency Exchange
Agreement” that covers currency swaps, and the other is the “Interest
Rate Swap Agreement” that lays out standard terms for U.S.-dollar-
denominated interest rate swaps. The standardized agreements have
reduced the time necessary to establish swaps and also provided terms
under which swaps can be terminated early by a counterparty.

Geithner Urges Tighter Regulation of Complex
InvestmentsBy VOA News 14 May 2009
 Treasury Secretary Timothy Geithner says complex financial
instruments called derivatives should be bought and sold with less
secrecy and more regulation.
The lightly regulated derivatives market is valued in the trillions of
dollars.
Some derivatives were intended as a kind of insurance to reduce the
risk of large and complex transactions. But instead, in some cases,
these instruments played a role in the collapse of major financial firms
and the start of the current economic crisis.
Late Wednesday, Geithner proposed that derivatives be traded on
regulated exchanges and that they be backed by a certain amount of
capital in case of default.
The idea must be considered and approved by Congress and the
President before it can become law.

End Chapter Six

Interest rates and currency swaps

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