22.6Hedging with Swaps

The last section noted that many financial contracts have a shorter term than the com-

mitments they try to hedge. The success of the swap market is due in part to swaps

typically having longer-term maturities than the contracts offered in the futures and

forward markets.

Review of Swaps

Swaps, discussed in detail in Chapter 7, are agreements to periodically exchange the

cash flows of one security for the cash flows of another. In addition to specifying the

terms of the exchange and the frequency with which exchanges take place, the swap

contract specifies a notional amount of the swap. This amount represents the size of

the principal on which the cash flow exchange takes place. The most common swaps

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Strategy, Second Edition

796Part VIRisk Management

are interest rate swaps,which exchange the cash flows of fixed- for floating-rate bonds,

and currency swaps,which exchange the cash flows of bonds denominated in two dif-

ferent currencies.

Swaps can be used to hedge a variety of risks. For example, corporations often

employ basket swaps to hedge currency risk. Basket swapsare currency swaps that

exchange one currency for a basket of currencies. Typically, this basket of currencies

is weighted to match the foreign currency exposure of the corporation.

Hedging with Interest Rate Swaps

Banc One’s use of interest rate swaps described by Backus, Klapper, and Telmer (1995)

illustrates how swaps are used for risk management. According to a 1991 issue of

Bankers Magazine,Banc One viewed itself as the McDonald’s of retail banking. Banc

One’s franchises, which consisted originally of a set of acquired Midwestern banks,

grew in the 1980s and early 1990s to include banks in the West, Southwest, and East.

All of these “franchises” have decentralized management whose decisions resulted in

a situation in which the collective assets of the franchises are more short term than

their liabilities. As a consequence, Banc One’s liabilities are more sensitive to interest

rate movements than its assets.¹⁰

Backus, Klapper, and Telmer computed that a 1 percent decline in interest rates in

the early 1990s resulted in an equity decline of about $180 million for Banc One. As

a result of this interest rate sensitivity, headquarters management at Banc One assumed

positions in interest rate derivatives in the 1990s, using mainly interest rate swaps with

a notional amount of almost $40 billion. Banc One reported that a 1 percent decline in

interest rates decreased net income by 12.3 percent without the swaps, but increased

net income by 3.3 percent with the swaps.

The Interest Rate Risk of an Interest Rate Swap.The key to interest rate hedging

with interest rate swaps is that the present value of the floating side of the swap has

virtually no sensitivity to interest rate risk, while the PVof the fixed side has the same

kind of interest rate risk as a fixed-rate bond. Hence, a swap to pay a fixed rate of

interest and receive a floating rate of interest generates the same interest rate sensitiv-

ity as the issuance of a fixed-rate bond. Conversely, a swap to pay a floating interest

rate and receive a fixed interest rate generates the same interest rate sensitivity as the

purchase of a fixed-rate bond. As a result, an interest rate swap can effectively change

positions in fixed-rate bonds into positions in floating-rate bonds and vice versa. Ignor-

ing credit risk considerations, rolled over positions in short-term debt have the same

risks as floating-rate debt. Thus, interest rate swaps can also be thought of as vehicles

for converting short-term debt into long-term debt and vice versa.

Converting Fixed to Floating.If the present value of the assets of a firm is insen-

sitive to interest rates, financing with a fixed-rate debt instrument creates interest rate

exposure, increasing equity value when interest rates rise and decreasing equity value

when interest rates fall. An interest rate swap can effectively convert the fixed-rate lia-

bility into a floating-rate liability, as Example 22.8 illustrates.

¹⁰In

contrast to Banc One, in the absence of hedging most large banks have income that increases

when interest rates decrease.

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Markets and Corporate			Companies, 2002
Strategy, Second Edition

Chapter 22

The Practice of Hedging

797

Example 22.8:Using Swaps to Convert a Fixed-Rate into a Floating-

RateLiability

Assume that First Federal Bank has issued a 5-year $1 million fixed-rate bond at the 5-year

Treasury rate 200 basis points (bp), paid semiannually, with principal due in five years.

First Federal would like to convert this into a floating-rate loan.How can it achieve this?

Answer:First Federal should enter into a $1 million national swap to receive a fixed rate

equal to the 5-year Treasury yield plus 200bp and pay LIBOR plus a spread.The receipt of

the Treasury yield plus 200bp effectively cancels out the fixed-rate payments on the First

Federal bond.The payment of the floating rate on the swap is all that remains.

The swap spreadfor a five-year swap is the number of basis points in excess of

the five-year on-the-run Treasury yield that the payer of the fixed rate must pay in

exchange for LIBOR. Hence, in Example 22.8, if the swap spread for First Federal is

50bp, the bank would convert a five-year fixed-rate loan at the five-year Treasury yield

plus 200bp into a floating-rate loan at LIBOR 150bp (200bp 50bp).

Converting Short-Term Debt to Long-Term Debt.If the assets of the firm are

highly sensitive to interest rate risk, the firm might desire fixed-rate debt financing to

offset this risk. However, as Chapter 21 discussed, a firm may expect its credit risk to

improve, and thus prefer rolling over short-term debt. The firm could then use a swap

to hedge the interest rate risk that arises with this strategy. This possibility is examined

in Example 22.9.

Example 22.9:Hedging Interest Rate Risk

Kaiser Automotive needs to finance a project that requires $100 million for five years.The

firm can obtain a fixed-rate loan for the five-year period with an interest rate of 10 percent

which is three percentage points above the five-year Treasury note rate.Alternatively, Kaiser

can roll over one-year bank loans to finance the project.Its current borrowing cost from such

a loan is 9 percent, which is three percentage points above the one-year Treasury note rate.

The bank has also agreed to enter into a swap contract with Kaiser in which the bank pays

Kaiser the interest rate on one-year Treasury notes, and Kaiser pays the bank 7.3 percent,

which is the interest rate on five-year Treasury notes plus 30 basis points.Kaiser is aware

that the demand for automobiles is closely tied to changes in interest rates and that it can

ill afford to be exposed to interest rate risk.However, it also believes that its cost of long-

term debt, 10 percent, is much too high given the firm’s current prospects.It believes that

within a year, its credit rating will improve and its borrowing costs will decline.What should

Kaiser do, and what are the risks?

Answer:Kaiser does not want to be exposed to interest rate risk, but it does want to

bet on its own credit rating.It can do this by rolling over short-term loans and entering

into the interest rate swap with a notional amount of $100 million.With this combined

transaction, the firm’s initial borrowing cost will be 9% 6% 7.3% 10.3%, which is

slightly higher than the cost of borrowing with a fixed-rate loan.However, if Kaiser’s credit

rating does improve next year so that its default spread is reduced from 3 percent to

2percent, its borrowing cost will drop from 10.3 percent to 9.3 percent and will not be

subject to changes in default-free interest rates.Of course, Kaiser’s projections may be

wrong and its credit rating may not improve, in which case the firm would have been bet-

ter off borrowing at a fixed rate.

Note that in Example 22.9, Kaiser is still exposed to interest rate risk on the

asset side of its balance sheet. Because of this, its default spread may be correlated

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Markets and Corporate			Companies, 2002
Strategy, Second Edition

798Part VIRisk Management

with changes in the interest rates. Specifically, Kaiser might be concerned that a

large increase in interest rates could lead to a drop in its sales, which in turn causes

its credit rating to decline. In this sense, the swap transaction described in the exam-

ple does not totally insulate the firm’s borrowing costs from the effect of changing

interest rates.

Hedging with Currency Swaps

Currency swaps can be used to create foreign debt synthetically. As the last line of

Exhibit 22.7 indicates, the cash outflows of foreign debt can be synthesized by com-

bining domestic debt (outflows in row a) with a swap to pay foreign currency and

receive domestic currency (net outflows as row cless row b).

Creating Synthetic Foreign Debt to Hedge Foreign Asset Cash Inflows.Allen

(1987) suggested that Disney’s profits from Tokyo Disneyland (net of its yen financ-

ing liabilities) created an exposure to yen currency risk for Disney in the mid-1980s.

This yen-denominated cash inflow was estimated at ¥6 billion per year and growing.

Disney could eliminate this yen exposure by issuing yen-denominated debt to a

Japanese bank, but management saw this as prohibitively expensive. Acomparable

strategy, albeit not exactly the one Disney followed, would have the company issue

U.S. dollar-denominated debt and enter into a currency swap.

Creating Synthetic Domestic Debt to Save on Financing Costs.Sometimes, firms

wish to issue domestic debt to hedge the interest rate risk of domestic assets. Example

22.10 illustrates that currency swaps also can be used to create domestic debt synthet-

ically. If a company’s debt issue is well received in a foreign country, the transaction

can result in lower debt financing costs.

Example 22.10:Using Currency Swaps to Create Domestic Debt

Assume that Motorola can issue a 5 million Swiss franc five-year straight-coupon bond at a

yield of 5 percent.In the United States, its comparable dollar straight-coupon debt issues

are financed at 8 percent.In the currency swap market, Motorola can swap the payments

EXHIBIT22.7Creating Synthetic Foreign Debt

		Year
1	2	3. . .	9	10

Net Cash Flows of $1 Million U.S.$ Debt
a.Outflows (in millions)$.09	$.09	$.09	$.09	$1.09

Future Cash Flows from 10-YearCurrency Swap $1 Million Notional Amount

b.Inflows (in millions)$.09$.09$.09. . .$.09$1.09

c.Outflows (in millions)

¥16

¥16

¥16

. . .

¥16

¥216

Total Outflows of Domestic Debt Plus Swap (in Millions) a c b
¥16¥16¥16. . .	¥16	¥216

Grinblatt1609Titman: Financial	VI. Risk Management	22. The Practice of Hedging	© The McGraw1609Hill
Markets and Corporate			Companies, 2002
Strategy, Second Edition

Chapter 22

The Practice of Hedging

799

of 5 percent Swiss franc bonds for those of 7 percent U.S.dollar bonds.How can Motorola

get a US$4 million loan synthetically at a yield of 7 percent? Assume that the current

exchange rate is 1.25 Swiss francs to the dollar.

Answer:

1.	Issue 5 million Swiss franc (SFr) notes at 5 percent.

2.

Enter into a five-year US$4 million notional currency swap in which paymentsequivalent to the semiannual payments from the 5 percent Swiss franc notes (SFr 125,000) are received.In exchange, Motorola pays 7 percent in dollars (US$140,000semiannually) and an additional US$4 million at the maturity of the swap.The cash received in Swiss francs on the swap funds the payment on the Swiss franc notes (interest and SFr 5 million principal), leaving only the U.S.dollar payments on oneside of the swap as Motorola’s obligation.

Example 22.10 shows that Motorola saves 100bp on its financing costs, or about

US$40,000 per year, because Swiss franc investors are treating Motorola relatively

more favorably than U.S. dollar investors. There are a variety of explanations for this,

but one reason simply is that Motorola may be offering Swiss investors a unique oppor-

tunity to diversify their bond portfolios. Because the number of Swiss companies issu-

ing bonds (for example, Nestlé), is relatively small and because the transaction costs

of investing in bonds denominated in foreign currency (and then converting back to

Swiss francs) may be prohibitively large, Swiss investors may be willing to pay a pre-

mium for Motorola bonds.