International Business Chapter 14

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Chapter 14 Which combination of the following statements is true about a swap bank? (i) it is a generic term to describe a financial institution that facilitates swaps between counterparties (ii) it can be an international commercial bank (iii) it can be an investment bank (iv) it can be a merchant bank (v) it can be an independent operator (i) and (ii) (i), (ii) and (iii) (i), (ii), (iii) and (iv) (i), (ii), (iii), (iv) and (v) A swap bank has identified two companies with mirror-image financing needs (they both want to borrow equivalent amounts for the same amount of time. Company X has agreed to one leg of the swap but company Y is "playing hard to get." If the swap bank has already contracted one leg of the swap, they should be hesitant to offer better terms to company Y. The swap bank could just buy the company X side of the swap. Company X should lobby Y to "get on board." If the swap bank has already contracted one leg of the swap, they should be eager to offer better terms to company Y to just get the deal done, and the swap bank could just sell the company X side of the swap. Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown here:

Fixed-Rate Borrowing Cost Floating-Rate Borrowing Cost Company X 10% SOFR Company Y 12% SOFR + 1.5% A swap bank proposes the following interest only swap: X will pay the swap bank annual payments on $10,000,000 at a rate of SOFR − 0.15 percent; in exchange the swap bank will pay to company X interest payments on $10,000,000 at a fixed rate of 9.90 percent. What is the value of this swap to company X? Company X will lose money on the deal. Company X will save 25 basis points per year on $10,000,000 = $25,000 per year. Company X will only break even on the deal. Company X will save 5 basis points per year on $10,000,000 = $5,000 per year. 10% + (SOFR − 0.15%) − 9.9% = SOFR − 0.05% Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown here: Fixed-Rate Borrowing Cost Floating-Rate Borrowing Cost Company X 10% SOFR Company Y 12% SOFR + 1.5% A swap bank proposes the following interest only swap: Y will pay the swap bank annual payments on $10,000,000 at a fixed rate of 9.90 percent. In exchange the swap bank will pay to company Y interest payments on $10,000,000 at SOFR − 0.15 percent; What is the value of this swap to company Y? Company Y will save 15 basis points per year on $10,000,000 = $15,000 per year. Company Y will save 45 basis points per year on $10,000,000 = $45,000 per year. Company Y will save 5 basis points per year on $10,000,000 = $5,000 per year. Company Y will only break even on the deal.

9.9% − (SOFR − 0.15%) + SOFR + 1.5% = 11.55%; 12% − 11.55% = 0.45%, or 45 basis points. Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown here: Fixed-Rate Borrowing Cost Floating-Rate Borrowing Cost Company X 10% SOFR Company Y 12% SOFR + 1.5% A swap bank proposes the following interest only swap: X will pay the swap bank annual payments on $10,000,000 with the coupon rate of SOFR − 0.15 percent in exchange the swap bank will pay to company X interest payments on $10,000,000 at a fixed rate of 9.90 percent. Y will pay the swap bank interest payments on $10,000,000 at a fixed rate of 10.30 percent and the swap bank will pay Y annual payments on $10,000,000 with the coupon rate of SOFR − 0.15 percent. What is the value of this swap to the swap bank? The swap bank will lose money on the deal. The swap bank will earn 40 basis points per year on $10,000,000 = $40,000 per year. The swap bank will break even. (SOFR − 0.15%) − (SOFR − 0.15%) + 10.3% − 9.9% = 0.4%, or 40 basis points. Use the following information to calculate the quality spread differential (QSD). Fixed-Rate Borrowing Cost Floating-Rate Borrowing Cost Company X 10% SOFR Company Y 12% SOFR + 1.5% 0.50 percent 1.00 percent 1.50 percent 2.00 percent

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Quality Spread Differential (QSD) = (12% − 10%) − (SOFR + 1.5% − SOFR) = 0.50% Swaps are said to offer market completeness. This means that all types of debt instruments are not regularly available for all borrowers. Thus interest rate swap markets assist in tailoring financing to the type desired by a particular borrower. In that the swap market offers price discovery to the market Because you can trade across both currencies and fixed and floating market segments In a currency swap , it may be the case that two counterparties have equivalent credit ratings. it may be the case that firms have a comparative advantage in borrowing in their domestic markets. Both A and B A major risk faced by a swap dealer is credit risk. This is the probability that a counterparty will default. the probability that both counterparties default. the probability floating rates will move against the dealer. In an efficient market without barriers to capital flows, the cost-savings argument of the QSD is difficult to accept, because it implies that an arbitrage opportunity exists because of some mispricing of the default risk premiums on different types of debt instruments. it implies that an arbitrage opportunity exists because of some mispricing of the exchange rates on different maturities of forward contracts. it implies that an arbitrage opportunity exists because of some mispricing of the default risk

premiums on different types of debt instruments, and it implies that an arbitrage opportunity. exists because of some mispricing of the exchange rates on different maturities of forward contracts. When a swap bank serves as a dealer, the swap bank stands willing to accept either side of a swap. the swap bank matches counterparties but does not assume any risk of the swap. the swap bank receives a commission for matching buyers and sellers. With regard to a swap bank acting as a dealer in swap transactions, interest rate risk refers to the risk that arises from the situation in which the floating-rates of the two counterparties are not pegged to the same index. the risk that interest rates changing unfavorably before the swap bank can lay off to an opposing counterparty on the other side of an interest rate swap entered into with the first counterparty. 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 transaction. the risk that a counterparty will not default.

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