International Financial Management

In 2014 US investors were snapping up dollar-denominated floating rate debt issued by corporations in anticipation that the Federal Reserve would begin to increase interest rates. Avis Budget Group saw an opportunity to issue $250 million of floating rate debt but promptly engaged in an interest rate swap to fix its payments at a low long-term rate because it didn't want to bear the risk of rising short-term rates. In July 2015 Starbucks reported that it had entered into cross-currency swap contracts during the first and third quarters of fiscal 2015 to hedge the foreign currency transaction risk of certain yen-denominated intercompany loans with a total notional value of ¥86.5 billion, or approximately $698 million.

This chapter examines interest rate and currency swaps, which are additional instruments for your risk management toolkit. We have previously discussed a number of ways of managing currency risks using derivative securities, including forward contracts in Chapter 3 and futures and options in Chapter 20. The maturities for these instruments are somewhat limited, whereas the maturities in the swap markets extend to 30 years or longer. We have also noted that exchange rate exposures can be thought of as arising from a general mismatch between assets and liabilities denominated in different currencies. We will see how interest rate swaps allow firms to change the nature of their liabilities for a given currency from fixed to floating interest rates or from floating to fixed interest rates. Currency swaps can be used to change the currency of denomination of a firm's liabilities. Changes such as these can be desirable as the nature of a firm's business changes. Swaps also allow firms to seek out low-cost financing without sacrificing their preferred type of debt.

Section 21.1 introduces the basic ideas associated with swaps and discusses the impressive size of the swap market. Section 21.2 provides a detailed analysis of the cash flows of interest rate swaps, and Section 21.3 provides a detailed analysis of the cash flows of currency swaps.

Introduction to Swaps

Swaps are contractual agreements between two counterparties to exchange a sequence of cash flows. In the modern swap market, over-the-counter dealers at major banks quote bid–ask spreads at which they are willing to do either side of a swap.