10.3 Techniques and instruments in the eurobond and euronote markets

interest rate rise or fall through interest rate swaps. For example, a speculator might

feel that interest rates are likely to fall and so offer a oating-rate stream (which will

fall as market interest rates decline) in exchange for a xed rate stream which will

not. If the speculator is right about the direction of interest rate change he will prot

from the swap. Box 10.6 provides an example of a failed interest rate swap.

Box 10.6

Failed speculation with interest rate swaps

In the 1980s the Hammersmith and Fulham local authority in London, seeking to max-

imise its income to counter the effects of restrictions imposed by the central government,

attempted to prot by speculation in interest rate swaps but ran up huge losses instead.

It entered the sterling interest rate swaps market on 1 December 1983. Council ofcers

had visited the London International Financial Futures Exchange (LIFFE), where the idea of

using swaps to reduce the sensitivity of the council’s borrowings to interest rate uctuations

was explained to them. An independent inquiry in 1991, however, showed that such was the

level of the user’s understanding, that the leader of the council and the nance department

were not clear whether they were interested in futures or options transactions. The council’s

activities in the money markets intensied in May 1987 when it began to become involved

in swaptions and other complex transactions, eventually totalling 550 transactions.

At the time, interest rates were falling and the local authorities gambled on their con-

tinued fall. Thus, in 1988 when the base rate of interest in the UK was 7.5 per cent, local

authorities swapped xed interest rate for oating interest rate loans of the same value

with hedging banks. The only payments made were for the net liabilities on whichever was

the higher – the xed or the oating rate. Thus if interest rates had continued to fall the

local authorities would have proted. Their aim was to pick correctly the trough in interest

rates and at that stage to reverse the swap, moving back to a xed interest rate, probably

at a lower rate than their original interest payments.

However, the local authorities were taken unawares by the sharp jump in interest rates,

which saw the base rate of interest rise to 15 per cent in 1989. They were then, under the

terms of the contract, required to pay large amounts to the banks – the difference between

the now very high oating rates and the xed rate on their original loans. Despite the volume

of contracts and the size of the risk, there was never any monitoring system established

to track the performance and possible dangers of their derivatives business. Happily for

them, the ratepayers of the most indebted local authorities were rescued by the courts,

which ruled that it had been illegal for the local authorities to use their funds in this way

and therefore that the contracts were unenforceable. The banks could be said to have

exposed themselves to legal risk– the risk of losing through a decision of the courts.

The price of a swap (the charge made by the swap bank for its services) depends

on the bank’s estimate of the extent of default risk, the ease with which it can obtain

a counterparty, and the term structure of interest rates in the bond market.

Currency swap:Contract that commits two counterparties to exchange streams of

interest payments in different currencies for an agreed period of time and to exchange

principal amounts in different currencies at a pre-agreed exchange rate at maturity.

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Chapter 10

• International capital markets A currency swap has three stages:

1.An initial exchange of principal: the two counterparties exchange principal amounts

at an agreed exchange rate. This can be a notional exchange since its purpose

is to establish the principal amounts as a reference point for the calculation of

interest payments and the re-exchange of the principal amounts.

2.Exchange of interest payments on agreed dates based on outstanding principal

amounts and agreed xed interest rates.

3.Re-exchange of the principal amounts at a pre-determined exchange rate so the

parties end up with their original currencies.

Again this may be done to hedge risk, to speculate on changes in exchange rates,

or to attempt to lower the cost of borrowing by borrowing in the currency in which

the most favourable interest rates are available and then swapping into the currency

that the rm needs to carry out its business. Whether this will be cheaper will depend

among other things on the bid–offer spread.

A xed rate currency swap is the exchange of a xed interest rate loan in one

currency for a xed rate loan in another currency. This also may be benecial to all

parties because borrowers may have different credit ratings in different parts of the

market. For example, a major international borrower, such as the World Bank, may

wish to raise funds in Swiss francs but may have a particularly high credit rating

in the US dollar market, allowing it to borrow in that market on very good terms.

Thus, it may choose to borrow in dollars and swap with, say, a US company with a

subsidiary in Switzerland.

A currency coupon swap is a combination of an interest rate swap and a xed rate

currency swap – both the interest rate structure and the currency are exchanged.

Other types of swap include equity swaps, agreements to exchange the rate of return

on an equity or an equity index for a oating or xed rate of interest. Equity swaps can

be used as an alternative to futures and options for hedging but are most attractive

to fund managers trying to outperform an index. The fund manager receives a stream

of payments replicating the return of a direct investment in an equity index and

makes in return a stream of payments usually based on LIBOR. An equity swap may

increase a fund manager’s ability to increase returns but because swaps, unlike futures,

can run for up to ten years, the default risk is greater, although exposure to it is

limited by payments normally being made every three months and because there is

no exchange of principal.

In a commodity swapthe counterparties exchange cash ows, at least one of which

is based on a commodity price or commodity price index. A high proportion of

the market is made up of oil-related transactions. A diff swap (or quanto swap) is the

exchange of the cash ows on an asset or liability in one currency for those in another.

A rm making a diff swap separates foreign exchange and interest rate exposure

by paying interest rates based on one currency while taking the foreign exchange

risk of another. The swap takes advantage of different-shaped yield curves to create

immediate cost savings for the borrower and allows an investor to receive higher

interest rates without changing currency exposure. Such an agreement typically runs

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