10.3 Techniques and instruments in the eurobond and euronote markets

end of the year, the Australian dollar has appreciated, the borrower will repay in

US dollars; if it has depreciated, repayment will be in Australian dollars. Reverse dual

currency bonds have also been issued, with the bond payable and the coupon rate

denominated in US dollars but repayable in other currencies. Sometimes borrowers

are given the option to repay in any one of a number of currencies.

Among the great variety of instruments and techniques developed in recent years,

perhaps the most interesting has been swaps. These are exchanges of cash ows that

originated as attempts by rms to manage their asset/liability structure or to reduce

their cost of borrowing. Cash ows generated by many different types of nancial

instrument may be swapped. Simple swaps such as interest rate and currency swaps

are known as plain vanilla swaps. There are many variations on these.

Interest rate swap:An agreement to exchange periodic payments related to xed

interest rates on a notional capital sum with those representing a oating rate on the

same sum in the same currency.

Closely related to the interest rate swap is the basis rate swap, which involves

the exchange of one type of oating rate for another. This can happen because, as

we have seen, a oating rate of interest is always expressed in two parts: a general

oating rate of interest that reects the rate at which banks themselves obtain

their money (the basis rate) plus a xed rate spread that is specic to each loan. We

have seen that the most commonly used basis rate in the London market is LIBOR

(the London Inter Bank Offered Rate). However, other rates may be used as the basis

rate of a oating rate loan, notably the US dollar prime rate and now, since the

establishment of the European Central Bank, EURIBOR. Thus, a basis rate swap may

involve the exchange of LIBOR for the US dollar prime rate in the calculation of the

interest rate payable on a loan. Let us take an example of an interest rate swap.

A company wishing to borrow will normally choose to do so in the market in

which it can raise funds most easily, perhaps from a bank with which it has done a

good deal of business in the past. We shall assume that this is a oating rate loan.

However, the funds are being raised to undertake a long-term investment project

and the rm, in order to be condent that the project is economically viable, would

like to know the interest rate it is going to have to pay. That is, it would prefer a xed

rate loan. Thus, it enters into an agreement to pass the liability (the interest payment)

on to another borrower in exchange for the xed rate structure that best suits it.

Swaps such as these are guaranteed by banks, often referred to as swap or hedging

banks. The swap banks do not lend anything in these transactions and so they do not

affect the banks’ assets and liabilities and thus constitute ‘off balance sheet’ business.

All that the swap bank does is to bear the risk that one of the parties to the deal might

default on its payments, leaving the bank partially liable for the interest payments

left unpaid by the defaulting borrower. Interest rate swaps work because different

intermediaries in the capital market do not always view a borrower in the same way.

Thus, our original rm may have been able to obtain a xed rate loan by issuing a

straight eurobond – but, if the rm was not well known to the market, the interest

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Chapter 10 • International capital markets

rate may have been higher than it could manage by borrowing on oating rate terms

from its own bank and swapping interest rate structures with another rm.

Box 10.5 provides an example of an interest rate swap. This example is one in

which payments are swapped, but receipts may also be swapped. Yet again, since

the capital sums are only notional, it is possible to speculate on the possibility of an

Box 10.5

An interest rate swap

A major defence industry supplier, Death Mines plc, wishes to borrow £1 million for twelve

years at a xed interest rate to nance a new investment project. It could do so by issuing

a straight eurobond but, as it is not well known in the market and does not have a high

credit risk rating, would have to pay a coupon of 8 per cent which it regards as too high.

The rm’s own bank is willing to lend Death Mines the required amount via a one-year

oating rate note at a rate of 2 per cent over LIBOR, currently at 3.6 per cent.

Clearly, the oating rate loan is much cheaper at the moment, but LIBOR could easily

rise over the period of the loan to such a level that Death Mines would nish up losing on

the project. Thus, it enters into a contract with a swap bank, Border International, to pay

to it 5 per cent on the principal, receiving in exchange LIBOR.

The position of Death Mines now is:
Pays to its own bank	LIBOR 2 per cent
Pays to Border	5 per cent
Receives from Border	LIBOR
Net position – xed rate loan at	7 per cent

But what of Border International? It appears to be running a serious risk here.

However, it would have entered into the above contract only if it were at the same time

entering into another contract with a counterparty which we shall assume to be a large

US multinational, GM Foods Inc. GM Foods is a prime borrower and so can borrow on

the eurobond market on the nest terms, but prefers a oating rate loan as it is willing to

gamble on interest rates falling in the future. Thus, it issues a straight £500,000 eurobond

with a coupon of 4.375 per cent. Then it enters into a contract with Border International

to pay Border LIBOR in exchange for a xed return of 4.75 per cent.

The position of GM Foods now is:
Pays on its straight eurobond	4.375 per cent
Receives from Border	4.75 per cent
Pays to Border	LIBOR
Net position – oating rate loan at	LIBOR 0.375 per cent

Border International’s position	now	is:
Receives from Death Mines			5 per cent
Pays to Death Mines			LIBOR
Receives from GM Foods			LIBOR
Pays to GM Foods			4.75 per cent
Net position – prot of			0.25 per cent

(Interest rate differentials such as this are often referred to in the market in terms of

basis pointswhere 1 basis point 0.01 per cent. Thus, 0.25 per cent is 25 basis points.)

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